What's a cliff, and what's it got to do with vesting?
There's a lot of jargon in finance, investment and even in business more broadly. Two words that don’t seem to go together, but actually do, are ‘vesting’ and ‘cliff’. To fully understand how a share option scheme works as a long-term incentive, you need to know what these two words mean.
Vesting is the process of gaining full ownership of an asset - in the case of a share option scheme, options.
A vesting schedule outlines the time it takes for someone's options to mature, i.e. vest. In other words, instead of being able to access their options immediately, that person effectively earns their options.
Vesting schedules vary from company to company, and while commonly time-based, they can also be tied to performance-based goals.
For instance, a company might decide that an employee needs to work for the business for five years before their options can fully vest. Or, they may need to hit a certain sales target.
We call it conditional equity. For best-in-class examples of the kinds of conditions you can set, check out our Conditional Equity Milestones guide.
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Once the entire vesting schedule is complete, the employee will have earned all of their options.
That's vesting in a nutshell. We'll talk about how crucial a vesting schedule is to your company share scheme later, but for now, let's move onto the cliff.
What's a cliff?
Nothing to do with land and everything to do with equity, a cliff is a welcome addition to a vesting schedule.
A cliff is a period of time that must pass before any options can start to vest, after which they do so on a set schedule.
Typically, a cliff is one year - that means that 12 months must pass before an employee's options can start to vest. Think of it like a probation period.
A common vesting schedule is four years with a one-year cliff. (See below).
But what does that mean? Let's take a look:
- The one-year cliff means that the employee needs to wait 12 months before any of their allocated options start to vest. It's usually on the first anniversary of their start date.
- It's not uncommon for folk to leave in their first year at a new company, so adding a cliff to their vesting schedule makes sense. Otherwise, an employee could move on after only a few months and take a piece of the pie with them.
- Then the four-year vesting schedule kicks in. Once the full five years is up, on a specific date, all of the employee's options are fully vested.
- But not necessarily 'unlocked'. Depending on how the scheme is designed, employees may not be able to exercise their options (i.e. convert into shares to buy or sell) just yet.
- Share option schemes can be exit-only or exercisable. If it's exit-only, they'll have to wait until an exit event has occurred.
- If it's exercisable, then they may be able to exercise some of their options before the entire vesting schedule is complete depending on the rules outlined in the option agreement.
In short, a vesting schedule with a cliff acts as a long-term incentive, encouraging employees to stick around and later claim their equity reward.
Choosing your vesting schedule
We've helped thousands of founders set up share schemes, and time-based vesting is the most common structure we see. But vesting doesn’t have to be time-based, it can be based on performance goals or a mixture of the two.
Having a mixture of the two is called ‘hybrid vesting’. It means that an employee must remain with the business for a set number of years and also achieve a performance-based milestone before all or some of their options vest.
Our intuitive scheme designer allows you to create a vesting schedule specifically tailored to your business and your team.
Book a free, no-obligation consultation with an equity consultant today and they'll show you just how easy it is.
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Are there any downsides?
Some new starters might be disappointed that they can't get their hands on their options right away.
Or see it as a risk. Before the initial qualifying period is complete, the contract could be terminated for some reason, e.g. a hostile business takeover.
Others will be buoyed by the incentive, and commit to staying with the company to help it grow to maximise their gains down the road - if the company grows in value, so does the value of their options.
A one-year cliff allows you to allocate employees options as soon as they join (rather than promise them they’ll get options later) motivating them right at the very start.
But if they leave within a year, they leave with nothing, protecting the business' best interests.
How do I set up an option scheme and design a vesting schedule?
Keen to get started? Look no further. Our equity consultants can help you choose the right share option scheme for your business, and show you the platform features that make designing a scheme and a vesting schedule simple.