Ready to understand how stock vesting works in startups? Stock options are quickly becoming an integral part of employee compensation. Startups love them and employees expect them. However, simply issuing stock options at once is not going to allow a company to get the true benefits of this employee compensation method.
Therefore, companies use various techniques to make sure they are getting the most out of the stock options they issued. Since salaries are usually low at startups, there is a high risk that employees might not stay for a prolonged period of time. So if the startup issued all the stock options to their employees at once, they would not have an incentive to keep working for their employer long term. In order to help improve employee retention, companies that issue stock options also use a vesting period to gradually transfer the stock options.
With that said, there is a lot of confusion among startups that wish to offer stock options for the first time about how stock vesting works. Not using a vesting period or failing to use it correctly when issuing stock options can do more harm than good. In this article, we will discuss what stock options are, what is and how stock vesting works, and the pros and cons that you will want to keep in mind when considering this employee compensation method.
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What are stock options?
If you want to fully understand what stock option vesting is all about and how it works, you have to first know how stock options work. An employee stock option is a form of equity compensation that the company gives to some employees or executives and others. Employees with stock options have the right to purchase shares of the company at a fixed price for a specific period of time.
Smaller companies rarely allow employees to exercise their options except in cases of an acquisition or IPO. So if you are a startup trying to issue stock options, you can choose to make the options exercisable only when your company goes public or gets acquired. This gives your employees an incentive to stay with your company until it gets more valuable and their stock options become more liquid.
Depending on a company’s stage of development, stock options can make up 5% to 15% of the company’s total shares. However, it is not uncommon for companies to issue as much as 20% of company shares as stock options during their early stage. Stock options have additional terms associated with them which govern how the employees can exercise them. However, the term that we are interested in is the vesting period of stock options, and that is exactly what we are going to explain in the next section, so keep reading.
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What is stock options vesting?
Equity is ownership in a company that you can offer to employees as part of their compensation package. However, as a startup, your goal is to retain employees and have them work for your company for a decent period of time. This is where the vesting period comes into the equation.
There would be nothing worse than employees simply getting all the stock options at the time of joining and then leaving the company soon after. To prevent this from happening, employers who offer stock-based compensation should control when an employee receives the options and a vesting period is a solution to the problem. Adding vesting into a stock options reward system is a way for startups to motivate employees to work harder and stay longer with the company.
With that said there are two common types of stock option vesting periods, so without further ado, let’s take a look at how they both differ from one another. You’ll also get an overview of how stock vesting works.
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Graded/linear vesting period
In the case of graded or linear vesting, as long as an employee stays with the company, they will receive a certain percentage of the shares promised to them over time. For example, if an employee has a gradual vesting period of four years, the employee will receive 25% after one year, 50% after two years, 75% after three years, and 100% after four.
Should the employee leave the company during the vesting period, the employee would receive only the percentage of stock options they have vested up until that time period. You may choose to use a reverse vesting schedule when issuing options to employees. With a reverse vesting plan, an employee gets all their shares in advance, but the company can buy back their shares if they leave early.
It is important to understand that cliff vesting schedules have a cliff period. This means employees don’t vest any shares until a certain point in time. Once the cliff period is over, the vesting schedule begins and employees gradually start to vest the stock options.
An example of a vesting schedule is a one-year cliff followed by a four-year linear vesting schedule. Initially, there would be no shares awarded to the employee, but over the next four years, the employee would gradually accumulate ownership of the shares. In the event the employee leaves before the cliff is over, they will not receive any shares. Startups rely on this plan to retain staff as they grow.
How does stock vesting work?
By now you should have some idea about how stock vesting works. In order to help you better understand how stock vesting works, and how it would get applied in an employee compensation plan we will use this hypothetical example:
We’ll take a look at an example of an organization that offers stock options as part of its compensation strategy. Imagine that the startup has granted one of its employees the right to buy 1,000 shares, vesting at a rate of 25% per year over four years, with a term of 10 years. Upon one year from the date of the option grant, the employee would be entitled to own 250 shares, 25% of the option grant. After two years from the grant date, the employee would vest another 25% until they own all 1000 shares.
In the event that the employee does not exercise their vested stock options after their first year of vesting, they would have a cumulative increase in exercisable options. So after year two, they will now have 50% vested stock options. If the employee doesn’t exercise their stock options in the first four years, they’ll have 100% of their options and the right to exercise them after the four years. Now it is up to the employee to decide whether they would like to exercise all the options at once or in stages.
In this example, the 10-year term of the stock options is also a key term to note, besides the vesting period. If the hypothetical employee in the example gets stock options and doesn’t use the right to exercise them before 10 years, they lose the right to exercise their options altogether. Therefore, in this example, the stock options must be exercised before the 10-year period from the time they are granted.
Pros and cons of using a vesting period
After reading about how stock vesting works and how startups can use it, you might well want to incorporate them into your own employee compensation plan. However, just like most business-related decisions, you have to weigh the pros and cons of the vesting period before you think about using it. Let’s take a closer look…
Pros of using stock vesting
Ability to retain cash flow
As a startup, there is nothing more important than holding on to the limited cash flow and using it to fund core business functions. However, using cash compensation to retain employees is only going to negatively affect your startup’s cash flow. When you use stock vesting however you can preserve cash flow and use equity compensation to retain employees over the long run.
The most important benefit of using stock vesting has to be the employee retention that comes with it. Having a high turnover of employees can hurt your business’s cash flow. When you are launching a new business, time and cash are highly valuable resources, which means that minimizing turnover is one of your primary objectives.
Share vesting is a very useful tool for retaining top talent and keeping them loyal to your company, as described in the previous sections of this article. Surveys show that the turnover rate of employees who have not completed their vesting period is generally lower in most companies. When your business is at its growth stage, current employees are incentivized to remain with your company not just to complete their vesting schedule but also to benefit from the growth of the company.
Improved employee performance
Employee productivity can be improved by using stock option vesting as part of their compensation. It is crucial to note that giving an employee shares turns them into part owners of the company and they feel like they have a direct stake in the growth and success of the business. Although they often own a relatively small percentage of the company, even a limited percentage of employee ownership can cause employees to shift from thinking about what’s best for them personally to thinking about what’s best for the company.
Share vesting in employee equity arrangements is ideal because it develops an ownership mindset in the employee while reducing the risk to the company. When conditions of share vesting are outlined carefully, it provides your employees with an incentive to perform better, depending on their performance milestones.
Cons of using stock vesting period
Failing to use a proper vesting schedule: An improper vesting schedule can seriously affect your company’s retention and cap table. It may be less motivating for employees to stick around until their vesting period is over if they don’t understand vesting or can’t track their own progress. Additionally, if an employee leaves the company with only partially vested options, it is hard to reconcile the unvested shares in the cap table in a timely manner.
It can’t replace direct pay
Although share vesting serves as a supplementary part of employee compensation, it does not replace the need for tangible pay in the short term. It’s important to strike the right balance between short-term compensation and long-term stock options compensation to ensure employee retention.
Just as share vesting can bolster an offer if the salary is below market, employees are unlikely to accept equity and especially shares that will vest if the rest of the compensation package does not address their short-term financial need. So if you are planning on using stock vesting, you still have to spend at least some amount of money on creating a short-term compensation plan for your workforce.
It is important to mention that before you can start using vesting schedules to retain employees you have to issue options in the first place. In order to issue options as a private company, your startup will need a 409 A valuation which can be costly and complex. So if you are trying to issue stock options and use vesting periods to retain employees, you have to consider the above-mentioned pros and cons of doing so.
In addition, it is best to have a legal and equity consultant on board when you are issuing stock options and creating a vesting schedule in order to get the most out of the vesting process.
Now that you know a lot more about how stock vesting works and vesting schedules, you are already halfway there as far as using vesting schedules is concerned. As long as you keep all the considerations we have suggested in this article in mind when creating a stock vesting schedule, you can boost employee productivity, reduce turnover and encourage employee loyalty.
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