Alternative Vesting Schedules Explained: What Founders and Employees Need to Know

A well-rounded team with top-notch skill sets is invaluable for a startup, and alternative vesting schedules can ensure employee retention. As an entrepreneur, you’ll explore fair compensation for your workers, preferably with a balanced mix of salary and stock options.

Stock options give employees an ownership stake in the company, effectively encouraging them to remain longer. They are also more inclined to work harder for its continued profitability and success. While offering option pools as its advantages, you’ll structure them carefully.

Investors examining the cap table will likely investigate stock options and vesting schedules assigned to workers. They’ll want an overview of the possible dilution when workers exercise their rights to claim company stock.

From the founder’s perspective, you’ll also want assurance that the company’s stock is secure if employees choose to exit. Also, determine how offering stock options will impact your tax liabilities. Here’s how alternative vesting schedules work.

Understanding Vesting or Vesting Schedule

When startups want to conserve working capital, they offer employees stock options to compensate for a lower salary structure. Option pools entitle the workers to own a part of the company. This stock is typically provided to top-performing employees in the company.

The vesting schedule is the time frame for which the employee must continue working for the company. Only then can they qualify to receive the stock options. This schedule usually ranges from three to five years and is pre-determined when offering the stock.

You’ll offer other benefits besides option pools, such as retirement funds like the 401(k). Any contributions you make to this retirement fund belong to the employee, even if they leave the company. In this way, they are 100% vested at any given time.

Employers must match dollar for dollar for whatever portion the employee diverts from their salary to the 401(k). However, employees must follow the vesting schedule to claim stock when receiving this incentive.

For instance, let’s assume you’ve allotted 200 stock units to an employee as a bonus. Further, the vesting schedule is five years. Accordingly, the employee gets 50 units in the second year after the bonus year.

They receive another 50 units in the third and 50 units in the fourth year. By year five, the employee can claim their 200 stock units. However, if the employee leaves the company after the second year, they will have vested only 50 units. The remaining 150 are forfeited.

When determining the appropriate structure, you’ll explore alternative vesting schedules and choose what works best for all stakeholders. Read ahead to understand in detail what your options are.

Alternative Vesting Schedules & How They Work

Alternative vesting schedules are essentially the structure you’ll choose instead of immediate vesting. With immediate vesting, employees can exercise the right to purchase the shares allotted to them in the company. This incentive does not carry any time or milestone conditions.

However, immediate vesting is often subject to reverse vesting clauses. If the employee leaves the company before completing a certain duration, they must forfeit the stock options they received.

Time-Based Vesting Schedules

Time-based vesting schedules are also called cliff vesting since the stock units are available to the employee after an interval. This interval is clearly specified in the terms, and employees become fully vested once they have worked in the company.

Cliff vesting is a simple plan to understand and execute with a clear timeline. For instance, if the cliff vesting period is 5 years, employees become fully vested at the end of this period. But if they leave at any time within 5 years, they forfeit their rights.

This condition creates a “cliff” effect, pressuring workers to remain with the company or risk losing their equity. The unvested stock reverts to the employee option pool. Companies may offer multiple grant options to their employees, and each grant has its own timeline and vesting schedule.

For instance, you could declare a grant with a four-year vesting schedule in 2025. If your earlier grant allotment was in 2023, the vesting schedule will follow the four-year timeline. Employees can claim their stock in 2027 and 2029, according to each grant’s vesting deadline.

It is crucial to understand that companies may offer special incentives to employees who have shown loyalty. You could align stock options and other benefits according to the long-term commitment you expect from them.

Then again, time-based vesting schedules could also be designed for a specific category of workers. For instance, if you’ve hired company advisors, their tenure within the company will likely be shorter. Accordingly, you’ll offer them stock with a shorter cliff of, say, one year or even six months.

Ultimately, you’ll choose the proper structure to match your company’s needs.

Graded Vesting Schedules

The graded vesting schedule is the most commonly used stock options structure. Employees become vested in a percentage of the stock allotted to them according to a staggered timeline. This period can be annually, biannually, or quarterly.

As mentioned in the foregoing sections, you could choose a timeline that varies according to your internal incentive policies. Typically, workers receive a percentage of their stock options each year. That is, until they become 100% vested at the end of the vesting period.

The graded vesting schedule encourages employees to remain with the company at least until the vesting period ends. However, maintaining records and administering stick options can be complex.

Keep in mind that storytelling is everything in fundraising. Your pitch deck with also include a team slide with information about the core team and skill sets. You’ll include the experience and value they bring along with success track records. Investors are likely to examine this slide carefully.

In this regard, for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

Remember to unlock the pitch deck template that founders worldwide are using to raise millions below.

Milestone Vesting Schedule

When scouting around for alternative vesting schedules, you’ll learn about the milestone-centric stock structure. According to this program, employees receive stock when the company achieves certain milestones. For instance, when launching its first product or successfully raising a funding round,

Offering the team stock options when the company goes to IPO is also a milestone vesting schedule. Or, say, when the company earns its target Annual Recurring Revenue (ARR) or a specific valuation. This strategy is effective in motivating employees to work toward a common goal.

Milestone vesting is a more performance-driven vesting approach. However, setting goals is a subjective process, and employees may not have much say in the management’s decisions. As a result, they may not agree with them or consider them reasonable enough to chase.

This incentive strategy can work only if you adopt complete transparency when communicating information about the stock options. Also, ensure that there is no ambiguity surrounding the sharing of data and metrics, which can indicate successful milestones.

Wording the milestone in clear and precise terms that resonate with the employees is crucial for this strategy to work. You may also have to set individual milestones for each category of workers. For instance, alternative vesting schedules for the marketing team will center around sales targets.

The team members will play a lead role in achieving this milestone and have first-hand information about the data. A specific valuation or successful funding round milestone is more suitable for the management team. Or, executives who will spearhead the fundraising initiative.

Ensure the milestone is reasonable, attainable, and expressed in a number or statistic. Its success should not hinge on the management’s opinion. For instance, customer satisfaction cannot be expressed in a number. Be wary of bad faith and unfairness issues.

Hybrid Vesting Schedule

If you choose the hybrid vesting schedule structure, it will include a timeframe and a milestone. These alternative vesting schedules combine the benefits of the time-based and milestone-based vesting formats.

Employees receive a portion of their stock options when they achieve a milestone. And another portion within a set interval. This structure is beneficial because of the flexibility and your ability to customize the plan according to the company’s needs.

On the flip side, organizing and administering stock options is complicated.

Accelerated Vesting Schedule

Before discussing accelerated vesting schedules, understand that stock options are not indefinite. Employees must exercise their rights within 10 years after receiving the grant. This means they can purchase the stock at a price lower than its market value.

However, if the worker quits the company, they must exercise the stock they have already vested within a fixed duration. This time limit can be 90 days or up to 3, 5, or 10 years, depending on the company’s discretion.

Alternatively, employees can accelerate the vesting process by exercising their stock options early. This means they can exercise their stock options before the vesting period ends, and they actually own the stock.

You can allow accelerated vesting if the company’s valuation continues to increase. Early vesting will enable workers to save on taxes. Sometimes companies may allow early vesting if they need to let go of workers before their vesting schedule ends.

A good example of such alternative vesting schedules was during the pandemic. Many companies had forced lay-offs and permitted accelerated vesting to compensate their employees.

Accordingly, let’s assume a worker has not worked for the company for a year. They will receive a portion of the equity they would have earned after the end of the one-year period. Then again, if the company is entering into an acquisition deal, it may accelerate the employee vesting schedule.

This process allows them to receive shares in the new company. For instance, an employee gets stock over a 5-year vesting schedule, but the company is acquired in the third year. The management may offer them accelerated vesting and allot all the stock due to them at the end of five years.

Longer Vesting Schedules

Retaining employees for extended periods, like five or six years, is advantageous for your company. They are likelier to be loyal, engaged, and dedicated to their work. You can expect higher productivity and stronger relationships, not to mention eliminating turnover costs.

Longer vesting schedules encourage a great team to remain with the company. But, for that to happen, you may have to offer a larger equity stake. You do have the option to offer multiple grants, even though they are not necessarily back-to-back.

However, every subsequent grant is allotted at a higher company valuation and could attract higher taxes. This is why, issuing grants with longer vesting schedules will allow employees to exercise their rights at lower share prices. At the same time, they can take advantage of lower taxes.

Longer vesting also indicates the worker’s commitment to remain with the company for an extended period. These alternative vesting schedules come with a duration of 6 years or more.

Back-Weighted Schedules

Companies often use back-weighted schedules to encourage employee retention and lower turnover. The principle here is that workers remaining for a longer period integrate into the company culture and continue getting promotions.

As they move higher in rank, they’ll take on more roles and responsibilities, and thus, deliver more value. Accordingly, the vesting schedule structure should stress loyalty and commitment by adopting a staggered approach.

For example, your company commits to offering 500 shares to top-performing employees. According to the back-weighted schedule, they can exercise 10% of their stock options in the first year, or 50 shares. In the next year, they can exercise 20% or 25%, which is 100 or 125 shares.

As the employee spends more time with the company, they receive higher percentages of stock options, which they can exercise. This strategy is ideal for startups in the pre-seed or seed stage. At this time, they are building their core team and hiring skill sets crucial for building the MVP.

Back-weighted schedules help you align incentives and choose people who see themselves working with the company for the next six years or more. You’ll build a team committed to long-term stability and success. At the same time, you’ll reward employees for the value they contribute.

The team and options pools you offer employees are only a few of the key slides of your pitch deck presentation. Here’s a video in which I have explained in detail what startup investors look for in entrepreneurs before investing.

Restricted Stock Units (RSU)

Depending on the terms of employment, you can offer employees Restricted Stock Units (RSU). These units are actual shares that they own, not stock options they can exercise later. However, issuing these shares often carries conditions for selling the stock in the open market.

For instance, the employee has to work for a fixed duration before they can liquidate the assets. Or they must wait until the company goes into IPO.

In Conclusion

As the founder, you can choose from alternative vesting schedules to reward your employees. Vesting schedules allow you to offer incentives while aligning them with the company’s limited resources and long-term goals. You’ll also reward loyalty and commitment.

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