Vesting Schedules — Beyond the Standard
TL;DR: The standard 4-year with a 1-year cliff vesting schedule is not the only option. Companies can use a number of alternatives to better align incentives, and even select for employees/founders with more loyalty and interest in long-term commitment.
This is not a post explaining what vesting schedules are — I make it a point to (try to) not duplicate content that others have already written about 10x on the web. See this post for a quick run-down.
Most people know that the “market standard” vesting schedule is 4-years with a 1-year cliff. That’s standard for employees, but also quite common for founders. I occasionally hear founders say that a founder team shouldn’t subject each other to a cliff, but generally I think that’s a bad idea. Some kind of cliff is a great way of ensuring that anyone there on Day 1 intends to be there for some meaningful amount of time. If they balk at a cliff, it says something; not entirely clear what it says, but it certainly says something of significance.
Advisors tend to have shorter schedules, like 1–2 years, because their grants are smaller and tenure tends to also be shorter. At least a 3-month cliff is always a good idea for advisors, in my opinion. If they balk, it, again, says something. Making small, reasonable requests in any kind of relationship, and observing the response carefully, can be a great way to gauge a person’s personality, motivations, and perspective; even if you consider the request itself immaterial and easy to drop.
However, for companies that feel like the standard approach doesn’t fit their context, or align incentives properly, there are a lot of smart alternatives that we’ve seen our client base adopt. Here are a few:
Instead of vesting based on time, you set it to occur upon certain milestones. These can be any number of things: achieving a certain financing, a certain revenue level, hitting a sales quota, etc. Whenever we see milestone vesting, the milestones tend to be contextualized for the individual. And certainly it only makes sense to have milestones that the individual recipient of the stock actually plays a lead role in achieving.
The benefit of milestone vesting is it can, when it works, better align “earning” equity with actually delivering results, as opposed to simple tenure based on time. However, the challenges that arise are (i) in the drafting — getting people to agree on reasonable milestones, (ii) in deciding when they’ve been achieved — who ultimately decides? the Board? the CEO?, and (iii) when circumstances change and ambiguity arises as to whether the milestone has been met. And of course, it is just more of a hassle to have to track milestones for vesting purposes as opposed to just letting the clock tick.
My strong suggestion to clients whenever they go with milestone vesting is to stick to milestones with objective, unambiguous metrics. Stay away from anything that depends on someone’s opinion — like “doing X to the satisfaction of Y person.” You’re just asking for trouble if you go there. Something like “achieving $X in cumulative customer revenue” will result in far far fewer disputes. And remember to use milestones that the stock recipient plays a significant role in helping the Company achieve. That too will prevent arguments over unfairness or bad faith as to person Y being responsible for why person X didn’t get their vested equity.
Longer Schedules (5–6 years)
There is a lot of value in attracting employees who intend to be with your company for the long-haul, as opposed to those who hop between employers. The sense of long-term thinking and loyalty that a long-term employee can bring to key projects can be hugely important strategically. I’ve always found the “perks wars” of certain tech ecosystems to be somewhat counter-productive, as they tend (in my mind) to select for employees with more mercenary personalities, as opposed to people who want to be there for much more important reasons.
I’ve certainly applied that thinking to how I recruit for MEMN. Honestly, if whether or not we offer free lunch or doggy sitting will influence your decision to work for us, I’d prefer you not.
Companies that deeply value long-term commitment will often consider having longer-than-standard vesting schedules; maybe 5 or 6 years. Of course, for this to work you generally need to provide an appropriately larger equity stake. Someone might ask why not, instead of one grant with a longer schedule, simply committing to do another grant after the standard 4-years?
It’s true that you can do that, and the standard approach is to provide ‘fresh’ grants to employees, for retention purposes, once their original vesting schedules run their course. However, (i) a grant made years later will have a higher exercise/purchase price (for tax purposes), so it’s actually tax favorable to do an earlier grant with a larger schedule, and (ii) there’s something about a longer schedule that just signals a person’s long-term commitment better, particularly if coupled with back-weighted vesting (see below).
If you’re looking to use vesting schedules as a way to gauge long-term commitment, back-weighted vesting is definitely an option worth considering. The concept is quite simple. Instead of vesting in equal installments over a schedule, the back-end of the schedule provides more vesting than the front-end. So instead of 25% vesting per year, Year 1 may be only 10%, but Year 4 may be 40%. There is definitely some logic to this idea, because the value someone delivers to their employer tends to go up over time, as they’ve become integrated into the culture, moved up in rank, taken on more responsibility, etc.
A longer-than-standard schedule with back-weighted vesting is one of the strongest messages you can send as to how much significance the Company places on loyalty and long-term employment. And as I mentioned before, if someone really balks at the idea, pay attention to what that tells you, because it definitely tells you something.
For key hires, the standard doesn’t always fit.
I hear it all the time: “just go with what’s standard.” I understand that approach, and it’s sometimes driven by an attitude that all of this legal mumbo jumbo doesn’t matter. Except for when it does.
For strategic hires, particularly in the very early days of a Company when your core team will totally make or break you, non-standard vesting schedules can be a valuable tool to align incentives, and “filter” for people who may not be as committed to the cause as you think they are. Remember: when someone says “no” to something you think is reasonable, it may not be fully clear why, but it tells you something. And that something can be very important.
Originally published at Silicon Hills Lawyer.