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There are many decisions to make when it comes to setting up a share option scheme for your employees. One of the most important is how your team’s share options will vest.
In this post, we cover what vesting is, what type of vesting schedule to go for and what the vesting period should be.
You don’t give your team their full annual salary on their first day. It’s the same when you give equity through share options. Most companies choose to parcel out their employee’s option allocation into smaller batches for the employee to gradually earn. That process of earning options is called vesting.
Vesting is one of several stages in the lifecycle of a share option, and just one of the stages that the employer can attach conditions to.
🤝grant or issue – when the employer gives an allocation of share options to the employee. Usually the employee doesn’t actually receive their share options until they satisfy the vesting conditions.
💼 vest – when employee meets the criteria and earns a batch of options.
💸 exercise – when the employee earns the right to ‘exercise’ their options and buy the shares they’re entitled to.
The vesting schedule will be set out in the option agreement. If your employee leaves before their options have vested, they lose their right to them.
A vesting schedule sets out how and when your employee earns their options.
Why is it important? Because your company equity is precious, and you don’t want to give it away without getting value back. A vesting schedule protects you from giving someone a slice of your company, only for them to leave the next day.
A vesting schedule incentivises your employees to stay with the company and/or hit key goals.
There are two main types of vesting schedule:
📅Time-based vesting – the employee earns their shares over a set period of time, usually over three to four years. This is known as the vesting period<jumplink to vesting period section>.
🏆Milestone-based vesting – the employee receives a certain number of options when they achieve a specific milestone<jumplink to milestone section> (for example, £1 million in sales)
Download our 2023 options report for free. We dive into the data to find the key takeaways to help you plan or evaluate your own scheme.Get report
In a time-based vesting schedule, the vesting period specifies how long it will take the employee to earn their full allocation of options.
On SeedLegals, it’s most common to choose a vesting period of four years.
Most companies also choose to add a vesting cliff to their option schemes. This means that the vesting period only starts for the employee after they’ve been with the company for a set time (usually one year).
The point of a cliff is to make sure that an employee only gets rewarded if they’ve stuck with the company for a decent amount of time. If they have only been working with you for a few months, they probably haven’t contributed enough value to have earned the right to any equity in the business.
The vesting frequency controls how often the employee earns a batch of options during the vesting period. This could be monthly, quarterly or annually.
A monthly vesting frequency is most common. Since most employees are paid their salary monthly, it makes sense to earn options at the same frequency.
There’s no right or wrong answer when it comes to choosing a vesting frequency. If your employees earn options on a quarterly or annual basis, it might motivate them to stay longer so they get their next batch of options. However, that might unintentionally encourage multiple employees to leave the business at same time, which could cause operational difficulties for your company.
Funding and Equity Strategist,
It used to be a hassle to run your option scheme with a time-based vesting schedule. You had to keep track of exactly how long people have been with you, whether they’ve passed their cliff and deal with the grant every month or quarter.
With SeedLegals, everything’s done automatically and you can track it all on one dashboard. Plus, your employees have a dashboard of their own, so they can see exactly where they are in the vesting schedule.
Milestone based vesting aligns your team’s compensation directly with wider company goals.
When done correctly, this type of option scheme can work well, especially for people in your team who are focused on one goal. For example, it might work better to tie options to goals instead of time for advisers and consultants you’ve hired to see through a particular project.
Milestone-based option schemes might not be the most effective solution for the long term, especially for your full-time employees. The chances are that goals you set for your team three years ago are markedly different to your priorities now. If the company’s goals change, that can unfairly affect the opportunities for your employees to earn share options.
Also, milestones can often be ambiguous, particularly for people in roles that don’t have metrics which are easily defined – milestones might work well for sales and marketing, but what about for roles in operations, HR and product?
What if you want to use options to directly reward achievement, but don’t want to limit yourself to milestone vesting? On SeedLegals, you can combine the strengths of time-based vesting and milestone vesting with performance options.
Performance options allow you to include share options in a new starter’s Employment Agreement, but defer deciding how many options to give them until you’ve assessed their performance. Talk to an options expert to find out more about how it works.
The data from the 2,500+ option schemes set up on our platform shows that the majority of companies go for time-based vesting, choosing 4-year vesting with a 1-year cliff and a monthly vesting frequency.
What does that mean in practice? After one year, the holder gains 25% of their share options and the remaining options vest each month, for the next 36 months.
A vesting schedule over four years is popular because it means founders get long-term commitment in exchange for the equity they’re giving away. The 1-year cliff also reassures the founder that they’ll have the opportunity to make sure the employee is right for the role before they start to earn options.
Funding and Equity Strategist,
When you build your scheme on SeedLegals, we check the details and automatically create the documents for you. And we’re on hand to guide you through at every step.
Not sure which type of vesting schedule is right for your company? Want to find out more about how we can help. Choose a time to talk to one of our equity specialists.