Vesting has become a popular concept in employee stock option plans, aimed at balancing incentives and retention. Vesting is a process by which employees earn the right to receive benefits from an employer's plan after a specified period. Cliff vesting is a type of vesting that has become popular, especially among startups.
In this article, we will discuss what cliff vesting is, how it works, its types, pros and cons, and how it differs from other types of vesting.
A 'cliff' refers to a specific period during which employees do not accrue any vesting rights. Vesting, on the other hand, is the gradual process by which employees gain ownership of employer-contributed benefits over time.
Cliff vesting is a process by which employees earn the right to receive full benefits from their employer's plan on a specific date, rather than becoming vested gradually over time. If a cliff vesting period is three years, the employee won't be fully vested until those three years are up. This means that the employee will not have access to the full benefits until they have completed the three-year vesting period.
Cliff vesting works by setting a specific date or time period before an employee can become fully vested in their employer's plan. Cliff vesting defers full vesting of employee equity or benefits until a predetermined service period is completed. During this cliff period, typically 1-4 years, the employee accrues vesting rights to the equity or benefits, without actual vesting occurring.
At the end of the cliff period, if the employee remains with the company, they will become fully vested in the entire stock option grant, restricted stock units, or other benefits immediately. This serves as the "cliff" - where vesting jumps from 0% to 100%.
There are three types of cliff vesting: time-based, milestone-based, and mix time-based.
Here are some of the key pros and cons of cliff vesting:
Overall, cliff vesting provides a substantial retention incentive for the long-term, but some limitations around flexibility and incentive frequency. Companies weigh these factors when designing plans.
There are different types of cliff vesting schedules, including 1-year cliff vesting, 3-year cliff vesting, and 4-year vesting with 1-year cliff.
In a 1-year cliff vesting schedule, if an employee leaves the company before the first year, they will not receive any benefits. After the first year, the employee would receive 25% of their shares vested, and the remaining shares would vest monthly over the next three years.
In a 3-year cliff vesting schedule, no portion of the benefit is granted until the employee completes three years of service, at which point they attain 100% ownership of the asset.
In a 4-year vesting with a 1-year cliff schedule, the employee would receive no benefits until the first year is over, after which they would receive 25% of their shares vested, and the remaining shares would vest monthly over the next three years.
Choosing a cliff vesting schedule depends on various factors, including the nature of the industry, employee preferences, financial considerations, and legal requirements. Companies ideally design their schedules based on their goals, objectives and competitor's strategies.
The most common cliff vesting schedule is four years with a one-year cliff, where employees receive no benefits until the first year is over, after which they receive 25% of their shares vested, and the remaining shares would vest monthly over the next three years. However, there are other types of cliff vesting schedules, including 1-year cliff vesting and 3-year cliff vesting.
Employers should also consider industry standards when deciding on a vesting schedule and offer benefits that are competitive with other companies in the industry, as this can help to attract and retain top talent.
Cliff vesting can act as a powerful retention tool for employers by tying the vesting of stock options to a specific time frame, but it can also create a high turnover risk and decreased employee morale.
Cliff vesting is a type of vesting that has become popular, especially among startups. It incentivizes employees to stay with a company for a longer period, helps companies manage the costs of offering benefits, and provides predictability for employees and employers.
However, it can be risky for employees if they leave a company ahead of the vesting date or if the company is a startup that fails before the vesting date. Companies should consider their goals, competitors, and the needs of their employees when choosing a cliff vesting schedule.
