Vesting refers to the transfer of ownership of financial instruments once certain conditions are met. You will commonly see vesting in two places: equity plans and 401k plans. The former is what we will spend time on in this article. The latter describes your ownership in a retirement fund, which your employer may contribute to each year. Most Stock Based Compensation (SBC) plans vest. Options may vest. Restricted Stock Units (RSU) may vest. Founder’s stock may vest too.
SBC vests over a period of three to five years. While you may be given options, you will need to remain with your employer to earn those options outright. Each vesting schedule has two components: the vesting schedule and acceleration provisions. The vesting schedule lays out the timetable for how you earn your SBC, and the acceleration provisions highlight which scenarios pull forward, or accelerate, your vesting schedule.
The Vesting Schedule
Say you are granted 10,000 options with a four-year vesting schedule. You can vest or earn these shares in different ways. Under a cliff vesting schedule, which is quite common, you will vest no shares for the first year. At the one year mark, you will vest 25% of your grant, or 2,500 options in this example, at once. The one year mark serves as the cliff.
In this example, you have vested 2,500 options but have 7,500 which remain unvested. Those will likely vest monthly over the remaining 36 month period. This means you will earn 208 options (7,500 divided by 36) at the end of each month until you vest all your options and become fully vested. If you have options, remember that being fully vested does not mean you have shares, and you have no voting power (yet). You still need to exercise your options. If you have RSUs or restricted, it is a different story. If you see a four-year vesting schedule with a one year cliff, now you know what it means. If you encounter one of these vesting schedules, be sure to clarify how you vest the remaining 75% of your SBC package after year one.
In other situations, you may see a graded vesting schedule. Graded simply means in portions, so there are many types of graded vesting schedules. You can vest 33% at the end of each year for three years. In other cases, you may see back-weighted vesting schedules where smaller portions vest early on. For instance, you may have a four-year vesting schedule where you vest a 15% portion at the end of year one, a 20% portion at the end of year two, a 30% portion at the end of year three, and a 35% portion at the end of year four. If you are being offered any form of equity, it pays to ask about your vesting schedule.
Who Has Vesting Schedules?
Any person who receives equity can have a vesting schedule. This includes employees, advisors, board members, and even founders. You may be surprised to see founders vesting. The argument for founder vesting is that you want to avoid a situation where a person is involved with a company early on, receives an equal portion of the equity when the business is incorporated, and departs shortly thereafter. You could end up with a major percentage of the business owned by someone completely uninvolved, and there is no way to get it back outside of buying it from him or her.
Founders raising their first round of Venture Capital (VC) financing may find that their investors ask them to put in place reverse vesting schedules to avoid this situation. Under a reverse vesting schedule, those with stock already enter into a new vesting schedule whereby they earn their equity, and if at any point in time during the reverse vest this person departs the company, the existing shareholders can repurchase the unvested shares at cost.
Single Trigger & Double Trigger Acceleration
Vesting sounds simple. You remain at a company for a certain number of years and vest over that period. However, you may be wondering what happens if your company is acquired and if you are fired shortly thereafter. These situations are where accelerations become relevant. Acceleration refers to the act of speeding up vesting schedules when specific circumstances occur.
There are two types of acceleration you may encounter. The first is single trigger acceleration, which refers to a set percentage of your unvested options or unvested shares vesting when one event occurs. This one event may be an acquisition, merger, or restructuring. The second type is double trigger acceleration, which is like single trigger acceleration but requires two events to occur. The first event is typically the same as before: an acquisition, merger, or restructuring. The second event is typically termination. You may see termination in situations where an acquiring company removes duplicate functions, such as finance, HR, or legal, shortly following an acquisition.
You should consult with your current or potential employer about the terms of acceleration in your equity offer. If you encounter a situation which triggers acceleration, there may be unintended tax consequences, so you should consult with a tax professional in that case.
When you receive any form of SBC, you do not receive a fixed percentage of the company, but you receive a certain number of shares, options, or units, which represent a percentage of the company at that point in time. You may receive 1,000 options, which is equivalent to 1% of the company at the time, but that is subject to change in so far as the denominator, or total shares outstanding, changes over time.
If you receive a stock grant which represents 1% of the company and vests over four years with a one year cliff, you do not vest 0.25% of the company at the end of year one. You vest a certain number of options or units at the end of year one. The lesson here is stock grants are always denominated in shares or units. Over time, your company’s share count will likely grow as it raises additional funding and hires new employees, so always think in terms of the number of shares and not only your percentage ownership.