Understanding Vesting and Cliff: Everything You Need to Know to Protect Your Equity
Are you about to embark on a startup journey and wondering about equity?
Or are you a seasoned entrepreneur looking to structure employee compensation packages that attract and retain top talent?
If so, it’s time to understand “vesting” and “cliff,” two terms that are fundamental to equity compensation.
In this post, we’ll break down everything you need to know about vesting and cliff and why they are crucial for protecting your equity.
What is Vesting?
Before we dive into the nitty-gritty of vesting, let’s start with the basics.
Vesting is a mechanism that regulates how ownership of equity is granted over time.
It means that you don’t own your equity upfront but instead earn it gradually, usually over a few years.
Also, read about startup term sheets.
Why is Vesting Important?
Vesting is important because it ensures that employees don’t receive their full equity allocation immediately and then quit, leaving the company with a significant amount of unearned equity.
Vesting allows the company to retain the equity until the employee has earned it, which helps align the interests of the employee and the company.
It also provides a sense of security for the company because it’s a way to ensure that the equity remains with the company if an employee leaves prematurely.
How Does Vesting Work?
The most common vesting schedule is the four-year vesting period with a one-year cliff.
A cliff means that an employee doesn’t receive any equity until they have completed a specific period of service, usually one year. After the cliff, the equity starts to vest gradually over the remaining vesting period.
For example, if an employee has been granted 1,000 shares with a four-year vesting period and a one-year cliff, they won’t receive any shares until they’ve completed one year of service. After the first year, they’ll receive 25% of the shares, which is 250 shares. After that, they’ll receive the remaining shares in equal installments every month for the next 36 months. If the employee leaves the company before the vesting period is up, they’ll only receive the vested portion of their equity.
What is a Cliff?
We’ve already touched on the concept of a cliff, but let’s delve deeper into what it means.
A cliff is a period of time during which an employee doesn’t receive any equity. It’s a way for the company to protect its equity and ensure that the employee is committed to the company for a specific period.
Why is a Cliff Important?
A cliff is important because it gives the company time to assess the employee’s performance and commitment before granting them any equity.
If an employee leaves the company before the cliff, they won’t receive any equity, and the company will retain the unvested portion of the equity.
A cliff also incentivizes employees to stay with the company and work towards long-term goals.
How Does a Cliff Work?
A cliff is typically set at one year, but it can be shorter or longer, depending on the company’s needs. Once the employee has completed the cliff period, the equity starts to vest gradually over the remaining vesting period. This is also called cliff vesting.
For example, if an employee has been granted 1,000 shares with a four-year vesting period and a one-year cliff, they won’t receive any shares until they’ve completed one year of service. After the first year, they’ll receive 25% of the shares, which is 250 shares. After that, they’ll receive the remaining shares in equal installments every month for the next 36 months.
Different Types of Vesting Schedules
While the four-year vesting schedule with a one-year cliff is the most common vesting schedule, there are other types of vesting schedules that companies can use, depending on their needs and preferences.
Graded Vesting
Graded vesting is a vesting schedule where equity is granted in equal installments over a set period.
For example, an employee might receive 20% of their equity every year for five years.
Graded vesting is often used for employee stock options.
Reverse Vesting
Reverse vesting is a vesting schedule where equity is granted upfront, but the company has the right to buy back unvested equity at a nominal price.
This is often used for founder shares or shares given to key members of the management team.
Performance Vesting
Performance vesting is a vesting schedule where equity is granted based on specific performance criteria, such as achieving certain revenue targets or hitting specific product milestones.
This is often used for executives or employees in key positions.
Key Takeaways
Understanding vesting and cliff is crucial for entrepreneurs and employees who want to protect their equity and ensure that it’s allocated fairly and transparently. Here are some key takeaways:
- Vesting regulates how equity is granted over time, ensuring that employees don’t receive their full equity allocation upfront.
- A cliff is a period of time during which an employee doesn’t receive any equity, and it’s a way for the company to protect its equity and ensure that the employee is committed to the company for a specific period.
- The most common vesting schedule is the four-year vesting period with a one-year cliff, but there are other types of vesting schedules that companies can use, depending on their needs and preferences.
- Vesting and cliff are important because they align the interests of the employee and the company, provide a sense of security for the company, and incentivize employees to stay with the company and work towards long-term goals.
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Conclusion
In conclusion, vesting and cliff are essential concepts that entrepreneurs and employees need to understand when it comes to equity compensation.
Vesting ensures that equity is granted fairly and transparently over time, while a cliff protects the company’s equity and incentivizes employees to stay with the company for a specific period.
By using the right vesting schedule, companies can attract and retain top talent, align the interests of the employee and the company, and ensure long-term success.
