Vesting and Cliffs — from The Holloway Guide to Equity Compensation

The following excerpt is from The Holloway Guide to Equity Compensation, a detailed reference with hundreds of resources on stock options, RSUs, job offers, taxes, and more. You can read more from this excerpt, or access the full guide text here.

Vesting is the process of gaining full legal rights to something — in this case, equity compensation. Executives, founders, and employees usually gain rights to their grant of equity incrementally over time, subject to restrictions. People may refer to their shares or stock options vesting, or may say that a person is vesting or has fully vested.

In the majority of cases, vesting occurs incrementally over time and according to a vesting schedule. A person vests only while they work for the company. If the person quits or is terminated immediately, he or she gets no equity. But if a vesting employee stays for years, he or she will get most or all of it.

Awards of stock, RSUs, and stock options are almost always subject to a vesting schedule. Vesting schedules can have a cliff designating a length of time that a person must work before they vest at all.

A very standard vesting schedule is over 4 years with a 1 year cliff. This means an employee gets 0% vesting for the first 12 months, 25% vesting at the 12th month, and 1/48th (2.08%) more vesting each month until the 48th month. If you leave just before a year is up, you get nothing, but if you leave after 3 years, you get 75%.

Sometimes vesting is triggered by specific events outside of the vesting schedule, according to contractual terms called accelerated vesting (or acceleration). Two kinds of accelerated vesting that are commonly negotiated are if the company is sold or undergoes a merger (single trigger) or if it’s sold and the person is fired (double trigger).

Cliffs are an important topic. When they work well, cliffs are an effective and reasonably fair system to both employees and companies. But they can be abused and their complexity can lead to misunderstandings:

• As a manager or founder, if an employee is performing poorly or may have to be laid off, it’s both thoughtful and wise to let them know what’s going on well before their cliff.
• The intention of a cliff is to make sure new hires are committed to staying with the company for a significant period of time. However, the flip side of vesting with cliffs is that if an employee is leaving — quits or is laid off or fired — just short of their cliff, they may walk away with no stock ownership at all, sometimes through no fault of their own, as in the event of a family emergency or illness. In situations where companies fire or lay off employees just before a cliff, it can easily lead to hard feelings and even lawsuits (especially if the company is doing well enough that the stock is worth a lot of money).
• As an employee, if you’re leaving or considering leaving a company before your vesting cliff is met, consider waiting. Or, if your value to the company is high enough, you might negotiate to get some of your stock “vested up” early. Your manager may well agree that is is fair for someone who has added a lot of value to the company to own stock even if they leave earlier than expected, especially for something like a family emergency. These kinds of vesting accelerations are entirely discretionary, however, unless you negotiated for special acceleration in an employment agreement. Such special acceleration rights are typically reserved for executives who negotiate their employment offers heavily.
• Founders often have vesting on their stock themselves. As entrepreneur Dan Shapiro explains, this is often for good reason.
• Acceleration when a company is sold (called change of control terms) is common for founders and not so common for employees. It’s worth understanding acceleration and triggers in case they show up in your option agreement, but these may not be something you can negotiate unless you are going to be in a key role.
• Companies may impose additional restrictions on stock that is vested. For example, your shares are very likely subject to a right of first refusal, which means that you can’t sell the stock without offering it first to the company. And it can happen that companies reserve the right to repurchase vested shares in certain events.