Vesting, Milestone or Exit-Only: Which share option scheme is best for you?

With the growing number of share options schemes being done on SeedLegals, we see founders asking:

1. What is a share option scheme? Who do you offer options to?
2. What vesting rules should we go with?
3. We’ve heard about exit-only schemes, what does that mean?

And, everyone tells us they’ve heard that option schemes are really complicated and really expensive. The good news is that was the past, SeedLegals has changed all that.

We used data from over 1,000 share option schemes done on SeedLegals to understand what choices companies are making when creating their option schemes. We then share that knowledge back via our team and tutorials on the SeedLegals platform and turn those choices into 1-click solutions to dramatically simplify the process for everyone.

So, here’s  a quick overview of option schemes and how to choose the right type of options for your team.

What is an option scheme and to who do you offer your options?

Granting someone options gives the right to buy shares in the future, but option holders don’t become a shareholder or get any rights associated with the shares at the time the options are granted to them. Instead, option holders will only become a shareholder and receive these rights when they actually own the shares.

Early-stage companies grant share options to their employees  to attract and retain the best talent as well as incentivise strong performance when they may not be able to pay high salaries. Betting on the growth of the company, employees often view options as a way to benefit despite a lower salary. 

Vesting

Having decided that you’re going to go ahead with an option scheme, the next thing is to decide how the options will vest. Vesting means that the employee needs to earn their options rather than just being given them all at once. 

Broadly, there are two types of vesting:

• Vesting by time – Vesting over a number of years
• Vesting by milestone – Vesting according to hitting agreed milestones

Vesting by time

For employees, vesting over a number of years is standard. For example:

• 3 years, starting from when the person joins, or
• 4 years, with a 1 year ‘cliff’ before any options start vesting

The first of these means that the employee begins earning their options from day one at the company. If they stay with the company for 1 year, 1/3rd of their options will have vested. If the options are being vested evenly throughout the vesting period, this is known as ‘straight-line vesting’.

At this point you might be thinking: if the person leaves the company after just 6 months, why should they get any options at all? Why should valuable share options, which could be used to incentivise other team members, be given to someone who bailed after a few months?

And that’s where the cliff comes in. Having a cliff period means your options start vesting only after a period of time, rather than on day one. For example, if there is a cliff period of 12 months, anyone who leaves during the 12 months  cliff gets nothing. When the cliff ends, they will be  immediately entitled to the full number of options as if there had been no cliff.

Vesting by milestone

For someone who is getting rewarded for delivering specific outcomes, you might instead choose to offer vesting by milestone.

For example, if you engage a third-party consultant or agency to build a mobile app for you, you would typically define a set of deliverables (milestones) and then pay them when they hit those milestones. Normally that would be payment in cash, but if cash is tight then you might, for example, agree to half payment in cash and half payment in share options.

In that case, you would select Milestone Vesting, and then define a number of  milestones with some fraction of the options vesting as each milestone is reached.

You may also  consider if you want to include a term that allows you to terminate the contract if things aren’t working out, in which case the third-party would be entitled to the options that have vested for the milestones they’ve hit, but no more.

When setting up your option scheme on SeedLegals, you can set up your preferred ways of vesting in a few clicks.

Exercising options

This is where it really gets interesting and also where founders get the biggest surprise, so let’s dive into Exercising.

The first thing is to understand is the difference between Vesting and Exercising:

• Vesting is earning more share options, typically over a period of years.
• Exercising is having the right to turn those share options into shares

Once you understand the difference, it’s obvious, but for many there’s a mental leap to get there, so let’s go through the mechanics:

• A share option is the right to buy a share at a future point at a price that you specify now, known as the exercise price.
• In the same way that you don’t pay your developers their entire annual salary on Jan 1, when you give your team share options, they’ll earn more share options each month, that’s the vesting.
• Once the employee has enough share options that have vested, they can exercise those options.
• To exercise their options, they pay the previously agreed exercise price to turn those share options into shares.
• By exercising their vested options, they’ll buy the share (usually at a steep discount to the actual share price at the time), and thereby become a shareholder in the company.

Let’s look at this step by step:

1. Jenny joins your company
2. You give Jenny 1,000 share options, vesting over 3 years
3. The option scheme rules allow Jenny to exercise her options any time she likes
4. One month later, Jenny is super excited that 1/36th of her options have vested
5. She writes to you to say she’d like to exercise 27 options

When someone wants to exercise their options they become a shareholder in your company, and that means the following needs to happen:

• complete the options exercise paperwork
• have the option holder sign a Deed of Adherence to become party to your last Shareholders Agreement (if you have one)
• seek approval and consent from existing shareholders
• work with your company/corporate secretary to (or on your own) issue and register the new shares

While most of this is neatly automated on SeedLegals, it’s clear that if you have dozens of employees exercising their share options each time a few more options have vested, it’s going to drive you crazy.

In the example above, the other thing to note is that once Jenny has exercised any of her options she becomes a shareholder in the company. Depending on the rights you assigned to those option shares, that might mean you need to provide her with quarterly management reports, and get her vote on company decisions. This may be appropriate for investors, but usually not something you want employees to have to get involved with.

Say hello to Exercise Windows

So, you’ll generally want to prevent employees from exercising their options at any time, and only allow them to be exercised at certain defined windows. 

On SeedLegals we’ve neatly factored that into 5 choices:

Let’s go through these in detail: 

1. Anytime

This gives your team the most flexibility to exercise their options as soon as they have any options that have vested and haven’t been exercised yet. This option makes sense if, for example, you’ve given someone options that vest according to a set of milestones so that they can exercise those options right after they’ve hit each milestone, if they wish to.

2. During a fixed period each year, e.g. Jan 1-15

The next step beyond that is to specify an ‘exercise window’, perhaps a two-week period once a year where anyone who has vested options that they wish to exercise, can exercise them then. That means you can group together all the new share issuances, and do just one filing update each year.

3. Only when the person leaves the company

While option two above solves the problem of team members calling you every month asking to exercise a few more options, it still leaves you with the issue that, if current employees are able to be shareholders, then you may have to provide management reports to those employees, and those management reports might contain, for example, budget and salary information that you would prefer to not share with your team.

So that’s where the “only when you leave” choice comes in. It means the person keeps earning their share options over a period of years, as normal. But, the only time they can exercise their options and become a shareholder is when they leave the company. This means you’ll never have employees who are still working at the company as shareholders.

Note that “only when you leave” does however mean that so long as they remain an employee, they won’t have the ability to sell their shares and make a capital gain to pay part of a mortgage – they would have to leave the company to do that. This is why on SeedLegals we include in the option scheme rules the right for the Board to override some of the rules, so that the Board can remain flexible when things come up.

4. Only on a sale of the company

Another way to limit having to issue shares to employees is to only allow options to be exercised on a sale of the company. This is interesting, because what you’re really saying is “Hey team, we’re on a journey together, when we have an exit we all benefit!”.

The median time for a startup exit is 5-7 years, so unless you’re planning for a fast acquisition or sale of the company, team members should treat this as a long game – i.e. hopefully you’ll get rich, but you’ll need to wait.

In this model, if someone leaves the company before an exit or sale of the company, they still keep their options, but they can’t exercise them until a sale happens.

5. Only on a sale of the company, and they lose their options if they leave before then

This is the high stakes, double-or-quit game of poker, the most controversial of the available choices.

This is commonly known as the “exit-only scheme”. The employee can only exercise their options on a sale, acquisition or IPO of the company (like choice 4 above). But, additionally, if they leave the company before that date, they lose all their options, including the vested ones.

By offering an exit-only scheme, you’re essentially telling your team: “Hey team, we’re on a journey together, when we have an exit we all benefit! But if you leave before we reach the destination, you’re out. Only the stayers are rewarded.”

From the company’s perspective, this is sending a powerful message that the company is there to reward employees who remain with the company for the journey.

Since many people change jobs every three years or so, it means that, like an airline that overbooks its flights knowing some passengers won’t show up, a company can give out more options to early team members, knowing that some fraction of those options will lapse, and they can then be reused for other later joiners. So the company doesn’t need to create as large an option pool, reducing dilution on the founders and early shareholders.

From the employee’s perspective, an exit-only scheme is in theory a motivator to stay with the company until the company exits, as intended. But it could also have the opposite effect: if employees perceive no exit in sight, or an exit that’s years away, they have no incentive to stay out their full vesting period since they’re going to lose everything anyway.

Choosing the right vesting schedule

Now that you know all the choices, there are three patterns that we see from our data:

For early joiners: 3- or 4-year straight line vesting, exercise anytime

Your first hires will usually be paid well below market salary, you just don’t have the funds to pay people market rate initially, and you’ll use share options to compensate them for the difference.

In this case, share options are a reward for work performed, in lieu of salary, and therefore it’s unfair for the person to lose that reward if they don’t stay until the company is sold or conducts an IPO, which may be 5-7 years away.

For that reason, it is common to see SeedLegals users offering a 3- or 4-year vesting period for early joiners of the company, exercisable anytime. However, you might want to add a 1-year cliff, so anyone who doesn’t work out and leaves your company within the first year doesn’t get that reward.

You can specify an exercise window. For example, option holders can only exercise their options in January each year. However, if you only plan to issue this type of options to a few early joiners, it’s not such a big deal to allow them to exercise anytime. The reason is that employees still need to make some amount of payment out- of-pocket to exercise all their options, which means they’ll usually hold off doing that until an exit, or until they leave. So, usually, they won’t ask to exercise until there’s an opportunity to sell their shares, which could be on an exit or future funding round and some time away.

For later joiners: Exit-only

Once you’ve gotten to Series A funding stage, you’ve raised sufficient funding to be able to pay your team market rate salaries. And that means options are now just a nice reward for staying the journey, rather than being used to compensate for a lower salary.

If someone is joining the company four years in, assuming the median time for a company to exit is approximately 5-7 years, they don’t need to stay that long until an exit comes. For these reasons, you may want to take an alternative approach for later joiners. This is why it is common to see SeedLegals users using the “we’re looking for you to be there with us for the journey” exit-only scheme at this stage.

You can mix and match vesting and exercise choices. For example, you can set three-year vesting with exercise on exit only. That means if someone joins 1 year before you conduct an IPO, they would be able to exercise 1/3rd of their options. Or you can specify accelerated vesting, so that on a sale or IPO, any unvested options vest immediately which allows anyone with the company to cash out nicely at that time.

For contractors: Vesting over the contract period, exercise on leaving

Unlike employees who are assumed to be there for the long term, contractors are usually hired for a fixed period, maybe six months, or a year.

With a contractor you might be paying them a mix of cash and share options (to keep the costs down), or even in share options only.

The differences between employees and contractors is that a contractor may only be with the company until a specific project is completed. In cases where you’re using options in lieu of cash, it’s only fair that the person keeps what they’ve earned during the period they worked with the company, meaning that an exit-only scheme might not be appropriate. Also, since a contractor is only around for a short period, it does make sense to say that they can only exercise their options when their contract is up (or before, if you terminate earlier).

Talk to our Options team