Vesting: Share-Based Incentive Program

Vesting, also known as equity vesting, is an essential concept that holds significant importance for both employees and investors in startups and established companies alike. Having a clear understanding of the definition and significance of vesting is crucial in making informed decisions regarding equity compensation and long-term investment strategies. In this article, we will delve into the concept of vesting, highlighting its importance and the implications it carries for both employees and investors.

Let’s begin with the definition of “vesting”. Vesting is the process by which an individual earns the right to own or exercise certain assets, such as shares, options, or other forms of equity compensation, over a specified period. In the context of corporate finance, vesting is typically associated with equity-based compensation, such as stock options or restricted stock units (RSUs). The purpose of vesting is to incentivize employees to remain with the company and contribute to its growth and success over time.

Employees who are granted equity compensation subject to vesting do not immediately own the entire grant. Instead, the ownership rights accrue over time according to a predetermined vesting schedule. The vesting schedule outlines the percentage of equity that becomes available to the employee at specific intervals, such as monthly, quarterly, or annually.

Once a portion of the equity grant has vested, the employee has the right to exercise or sell that portion, subject to any applicable restrictions or tax implications. Unvested equity, on the other hand, cannot be exercised or sold, and may be forfeited if the individual leaves the company before the vesting period is complete.

WHY USE VESTING?

The purpose of vesting is to provide employees with incentives to remain with your startup over a certain period. Vesting serves several objectives:

1. Retention: By tying a portion of an employee's compensation to a vesting schedule, companies encourage employees to stay and work towards long-term goals. Employees need to remain with the company for a certain period to fully realize the value of their stock options or equity grants.
2. Aligning interests: Vesting helps align the interests of employees and the company. As employees' equity or options vest over time, they become more invested in the company's success, as their financial well-being is tied to the company's performance.
3. Performance motivation: Vesting can be structured to reward employees for meeting specific performance targets. Companies can motivate employees to work harder to achieve these objectives by tying equity or options to performance goals.
4. Risk management: For the employee, vesting can provide a degree of risk management. Since the employee's equity or options become more valuable over time, they have an incentive to work diligently to ensure the company's success and protect their investment.

WHAT IS A VESTING PERIOD?

A vesting period is a predetermined timeframe during which an employee gradually earns the right to own or exercise their granted equity, such as stock options or restricted stock units (RSUs). It typically begins when the equity grant is made and ends when the entire grant has vested—according to the specified vesting cycles.

This period serves to incentivize employees to stay with the company and contribute to its long-term growth and success.

Vesting cycles

Vesting period meaning is closely related to vesting cycles, which are the intervals at which the granted equity vests and becomes exercisable or sellable by the employee. The vesting period governs the overall duration of these vesting cycles, ensuring that employees remain committed to the company over an extended period.

Understanding vesting periods is crucial for employees and employers alike, for several reasons:

• Employee retention: Vesting periods serve as a powerful tool for companies to retain valuable employees by tying a portion of their compensation to the company's long-term success.
• Long-term incentives: The vesting period encourages employees to focus on the company's long-term growth as their equity compensation increases in tandem with the company's value.
• Financial planning: Employees need to be aware of their vesting periods to plan for tax implications and other financial considerations related to their equity compensation.

WHAT IS A VESTING SCHEDULE?

A vesting schedule is a predetermined plan that outlines the percentage of equity available to an employee at specific intervals during the vesting period. Vesting schedules can vary significantly depending on the company, the type of equity grant, and the employee's role within the organization.

There are several types of vesting schedules commonly used in equity compensation plans. Some of the most prevalent include:

1. Time-based vesting: Time-based vesting schedules grant equity to employees solely based on the passage of time. An example of a typical time-based vesting schedule is the "four-year vesting with a one-year cliff." Under this schedule, an employee must remain with the company for one year (the cliff) before any portion of the equity grant vests. After the cliff, the remaining equity typically vests monthly or quarterly over the next three years.
2. Performance-based vesting: Performance-based vesting schedules tie the vesting of equity to the achievement of specific performance milestones. These milestones can be based on individual, team, or company performance, and may include metrics such as revenue growth, profitability, or other key performance indicators (KPIs).
3. Annual vesting: Under an annual vesting schedule, a fixed percentage of the equity grant vests at the end of each year, typically over three to five years. This schedule can be combined with a cliff, requiring the employee to remain with the company for a specific period before any equity vests.

How do vesting schedules work?

Vesting schedules work by allocating portions of an employee's equity grant to vest at specific intervals throughout the vesting period. Once a portion of the equity grant has vested, the employee can exercise or sell that portion, subject to any applicable restrictions or tax implications. Unvested equity, on the other hand, cannot be exercised or sold and may be forfeited if the employee leaves the company before the vesting period is complete.

Vesting schedule choices can have a significant impact on employee retention and motivation. Time-based and annual vesting schedules generally offer more predictable vesting, allowing employees to plan their financial future with greater certainty. Performance-based vesting, on the other hand, can drive employees to focus on specific goals and outcomes, potentially leading to faster company growth.

Standard vesting schedule

The length of a vesting period can vary depending on the startup, the type of equity grant, and the employee's role within the organization. A common vesting period is four years, often with a one-year cliff. This means that the employee must remain with the startup for one year before any portion of the equity grant vests, after which the remaining equity vests over the next three years.

Other vesting cycles may include performance-based vesting, where equity vests upon achieving specific performance milestones, or time-based vesting, where equity vests are solely based on the passage of time.

WHAT IS A VESTING DATE?

A vesting date, also known as vesting commencement date, vesting start date, or vesting grant date, is a specific point in time when an individual becomes entitled to the full value or benefits of a particular asset or plan. The asset in question could be company shares, retirement funds, or other benefits provided by an employer. The vesting date is a crucial milestone in an equity or benefit plan, as it determines when an employee can exercise their rights or claim the promised benefits.

The term "vesting date" might sound confusing at first, but its meaning is simple. It is the date on which the rights or benefits granted to an employee under a specific plan become unconditional and non-forfeitable. In other words, once the vesting date is reached, the employee can take full advantage of the asset or plan without the risk of losing it due to termination, resignation, or other factors.

What is a vesting date in the context of equity and benefits?

When it comes to equity and benefits, the vesting date plays a pivotal role. Companies often use vesting as a tool to retain and motivate employees, offering them valuable assets that will become theirs only after a certain period of employment or upon achieving specific milestones.

In the context of stock options or restricted stock units (RSUs), the vesting date refers to the point in time when an employee can exercise their options or sell their shares. Before the vesting date, the employee cannot access or monetize these assets. Once the vesting date arrives, however, the employee can choose to exercise their rights, which may result in financial gain.

Similarly, for retirement or pension plans, the vesting date is the moment when an employee becomes fully entitled to the benefits accrued in the plan. Before reaching the vesting date, an employee may only be partially vested or not vested at all, which means they may lose some or all benefits if they leave the company or retire early.

IMPORTANCE OF VESTING FOR EMPLOYEES AND INVESTORS

Understanding the definition of vesting is essential for both employees and investors for several reasons:

1. Employee retention: Vesting serves as a powerful tool for startups to retain valuable employees by tying a portion of their compensation to the company's long-term success.
2. Long-term incentives: Vesting encourages employees to focus on the company's long-term growth, as their equity compensation becomes more valuable as the company's value increases.
3. Tax implications: Employees need to understand the tax implications of vested equity, as the exercise or sale of vested shares or options may trigger tax liabilities.
4. Investment strategies: Investors must consider vesting schedules when evaluating the potential value of equity-based compensation, as unvested equity may be subject to forfeiture or dilution.

ACCELERATED VESTING

When certain conditions are met, vesting can be expedited from the standard timeline that an equity grant would otherwise vest. This is called vesting acceleration.

Who should accelerate vesting?

While accelerated vesting benefits the equity holder, companies should take care when including acceleration in equity grants. Factors such as the type and quantity of vesting acceleration provisions may alarm investors or potential buyers.

Defining your company's philosophy around vesting acceleration starts with understanding the varieties of acceleration and the market trends surrounding each.

How common is double-trigger acceleration?

While double-trigger acceleration is commonly employed to protect founders, offering it to all employees is even less common. If every employee had the double-trigger acceleration option, a potential buyer would only make personnel changes with a prohibitive number of shares being granted to departing employees via acceleration provisions.

While each company should develop its own compensation philosophy, founders should design compensation with care because it can become strategically important down the line.

Single vs. double-trigger acceleration

Single-trigger and double-trigger acceleration are two types of vesting acceleration in employee equity agreements.

Single-trigger acceleration means that upon the occurrence of a specific event, typically a change of control or acquisition of the company, a portion or all of the unvested equity awards become immediately vested.

On the other hand, double-trigger acceleration requires the occurrence of two events for the equity to vest. Typically, these two events are a change of control or acquisition, followed by the termination of the employee's employment without cause or for a good reason.

In essence, single-trigger acceleration accelerates vesting based on a single event, while double-trigger acceleration requires two events to occur before vesting is accelerated.

KEY TAKEAWAYS

So, what do you need to know about vesting? First and foremost, it's a way to ensure that founders and employees don't walk away with all the company's shares when they leave. By requiring that shares be vested over time, everyone has an incentive to stay on board and help the company grow. Second, there are different types of vesting schedules, so you'll want to choose one that fits your company's needs. Finally, if you're not sure how vesting works or which schedule is right for you, don't hesitate to call us.