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Option Schemes Mar 2, 2020 3 min read

Choosing the right vesting schedule for your Share Option Scheme

At SeedLegals our Option Scheme product allows founders to design a perfect scheme and gives them total flexibility.

There are broadly three types of Option Scheme

  1. Exit only – any employee that’s with the company when it’s sold cashes out – but if you leave early – you’re out of luck
  2. Milestone based – if an employee hits a certain milestone (e.g. £1m in sales), they earn a certain number of Options
  3. Time Based – an employee will earn their shares over a set period of time – normally 3-4 years.

Introducing Vesting

The above are examples of vesting – essentially putting conditions on equity that you give out to employees. You obviously don’t want to grant someone a slice of your company, only for the next day them to leave. But as a Founder you’ll need to decide what kind of scheme is right for you. There are various pros and cons:

The good, the bad & the ugly of Options Schemes

Exit only

An exit-only option scheme used to be the default game in town. That’s because most law firms were lazy and pushed it on to their customers – because it’s really simple to run. If you’re here when we sell, great! Everyone else, well you didn’t stick around…

Superficially it looks reasonably attractive to Founders. It rewards those that stick it out and has people focused on an exit – to the benefit of the existing shareholders. But what about the person that’s worked on the business for years and leaves shortly before an exit being penalised, versus the person that luckily joins shortly before the sale.

Also, the entire point of an Option Scheme is to motivate and retain staff. We’ve run the numbers at SeedLegals – and an exit only scheme just doesn’t do those things as well as the alternatives – especially if the company is so early stage an exit is seen as quite a distance away.

So while you, of course, you can set up this kind of scheme on SeedLegals, we normally direct people towards the alternatives.

Milestone based

Milestone based vesting aligns your team with them achieving wider company goals – so when done correctly – they can work – especially for people in your team (for example an adviser), whose sole job it is to achieve, say, the closing of the next company funding round.

However, as soon as we look to the longer term, they might not be as appropriate. If you look at your objectives three years ago – the chances are they are a great deal different to where they are now – and so if the company’s goals change – that can unfairly impact an employee’s equity.

Also, milestones can often be ambiguous, particularly for people in roles that don’t have as easily defined metrics as sales and marketing e.g. operations, human resources and product.

So while there can sometimes be a place for milestones to accelerate, and of course you should track objectives with all employees, for a company-wide share option scheme, we prefer the alternative: Time.

Time-based vesting

At SeedLegals our strong preference, which is backed up from all of the data from the hundreds of Share Option Schemes we’ve helped companies set up, is that of time-based vesting. There are a few terms to cover, firstly:

Vesting Period

The time required for an option holder to earn all of their options given in a grant.

Cliff Period

The minimum time required for an option holder to start vesting any of their options.

A Cliff Period ensures that an option holder only gets rewarded if they have stuck around 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 earn any equity in the business.

Vesting Frequency

How often the option holder earns shares in their schedule, whether it’s monthly, quarterly or annually.

Having a period longer than monthly can motivate individuals to stick around until the next portion of options vest, but also might lead to many employees leaving the business at a similar time, especially if you choose annual vesting.

Our data shows us that the most common selection is  ‘4-year vesting, with a 1-year cliff & monthly vesting frequency’. After the first year 25% of the options will be vested and the remaining amount will vest each month, for the next 36 months.

Time-based vesting used to be less popular because you’d have to keep track of exactly how long people have been with you, whether they’ve passed their cliff and more – but thanks to SeedLegals, you can track this easily on one dashboard.

As time-based vesting most closely aligns employees with founders and is generally the fairest, the vast majority of companies on SeedLegals set up this kind of scheme.

So, what type of option scheme is right for you?

That is up to you to decide. Previously setting up an EMI Scheme in place was a complex, time-consuming & expensive process. At SeedLegals, we’re changing and dramatically improving this – so you can set up any kind of Option Scheme in just a few clicks.

As with all SeedLegals products our team is on hand to help every step of the way. 

Book a demo now.

AJ Alao

AJ Alao

Accounting specialist (and American Football coach) AJ is our expert on option schemes.
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