The importance of vesting
When you hear somebody talking about all the important things to remember when offering and designing an equity compensation plan for your company, you’ll probably hear a lot of jargon-filled advice, going through a long list of features. And it’s true, there are a lot of things to remember. You need to use a plan that best suits your company and employees, you need to balance the benefits to you of a long-term plan with the desirability of joining the plan, and you need to make sure you’re offering the right amount of equity.
But if we could offer one piece of advice, the most important advice we can give, it's to implement vesting rules. Vesting rules are one of the most important parts of your equity compensation plan. This particularly applies to startups and SMEs, who are just starting out – but it applies to larger companies as well.
Let’s take a look at what vesting rules are, and why they’re so important.
What are vesting rules?
The first thing to understand is the term vesting. What does it mean for an award to vest? It means that the award actually belongs to the recipient now.
For example, imagine a company offers you an award of 100 shares, with a vesting period of one year. This means that they will grant you the award, but you cannot do anything with the shares (sell them, etc.) until one year later. After a year, they’re yours – they have vested.
That’s a common type of vesting known as cliff vesting. In graduated vesting (also known as ratable or graded), part of the award vests –becomes available – in intervals.
For example, if a company offered you an award of 300 shares, with a graduated vesting period of three years, then after your first year you would receive 100 shares. The next year, 100 shares, and 100 shares the next year.
There are, of course, advantages and disadvantages to both. It depends on what your company needs, and what is best suited for your industry and jurisdiction.
Why they’re important – SMEs
Establishing vesting rules for your equity compensation – and getting them right – is vitally important. Vesting rules are a great incentive for employees to remain with the company for a longer period of time. Just make sure you balance the benefits to your company with the attractiveness of joining the plan for employees.
For example, a cliff vesting with a long-term vesting period of three or five years might sound attractive for the business. But realistically, a bonus five years in the distance – no matter how big a bonus – is not likely to influence behavior. But a cliff vesting period of one year, or a graduated vesting period of three years, can keep employees not only with the company but motivated as well.
Why they’re important – Startups
Vesting rules are important for SMEs, but they are crucial for startups. They prevent you from giving away too much of your equity, and when you’re a startup, any little bit of your equity you give away without significant return is catastrophic.
For example, imagine a startup with two founders and three employees. They have split the equity with each founder owning 35% of the company, and the employees owning 10% each. There are no vesting rules, so as soon as the employees joined, they received their full equity, just as the founders already had all their equity.
Then, one day, a founder leaves. And maybe she takes one of the employees with her, to start up a new company. Can you see the problem? 45% of the company has just walked away, taking every single one of those percentage points with them. There's nothing the company can do – from now on, those leavers don't need to do anything, and they will receive 45% of the rewards. Not only that, but the startup now has 45% less equity for investors and future employees. The startup is no longer a start-up, it’s a close-down.
Now, that was just an illustration – but it drives home the essential point. No matter how great your leadership, or how amazing your employees are, you are going to have people leave. It’s inevitable. And your equity is the most valuable thing you have – if you let it walk out the door with those leavers, your business will most likely not recover.
On the other hand, your employees need something to aim for, and to motivate them, and they need to be fairly rewarded. So, you need to balance these two. And you do it with vesting rules. If that founder and employee had graduated vesting, for example, they would have left with significantly less equity – enough to reward them for the work they had done, and no more.
The vesting schedule is also an important consideration. Vesting refers to the goals the employee has to meet in order to receive their incentive. So, if an award vests after three years, once the employee has completed three years of service then they receive their award. Or, if there are performance conditions – for example, the employee has to hit certain sales targets – their award vests after they reach these milestones. There are different types of time-based vesting (cliff, ratable, etc.) as well as different types of performance-based vesting. The most important thing to consider again is what suits your business best, and what will incentivise your employees most.