To Vest or not To Vest, that is the question

When establishing a share option scheme, a key decision revolves around how to structure the vesting of the options. Vesting, though sometimes misunderstood, refers to the period over which employees earn the right to exercise their options. Essentially, it’s the time or conditions employees must meet before they gain full ownership of the options granted to them.

What Is Vesting?

The concept of vesting is straightforward: employees don’t receive the full benefits of their options right away. Instead, they gradually "earn" them over time or based on specific conditions. This mechanism helps ensure employees remain engaged with the company and contribute to its long-term success before benefiting from the scheme.

Aligning Vesting with Company Goals

Before setting the vesting structure, the company’s medium and long-term goals (over 5-10 years) must be considered. What is the company trying to achieve, and what behaviours should the options incentivise?

• Vesting on Exit: If the company aims to be acquired in the next few years, a vesting scheme tied to an exit event, such as a company sale, can motivate employees to stay and work towards that common objective. This is especially suitable for loss-making startups developing valuable intellectual property (IP) that they are looking to sell to a competitor or larger business in the future.
• Time-Based Vesting: On the other hand, if the company is revenue-generating or at least cash-flow positive and aims to create long-term value, distributing dividends to shareholders, time-based vesting over several years is more appropriate. This type of vesting motivates employees to build the company’s revenue, reduce costs, and ultimately benefit from its success through both share ownership and potential dividend payouts.

Of course, there are many variations in between these two scenarios, and companies often tailor vesting schemes to meet their unique circumstances.

Performance-Based Vesting: A Cautious Approach

Another approach is performance-based vesting, where options vest based on specific metrics, such as the company reaching a certain valuation or revenue target. While these conditions can align employee incentives with business goals, they come with risks. For example, how do you accurately measure the company's valuation, or what type of revenue qualifies? What happens if the company narrowly missed out on a target, would it be fair for that employee to not have their options vest?

These schemes can be complex to manage and execute, and as such, they are less common and should be implemented with caution.?

The Role of Cliffs in Vesting

A cliff refers to the initial period during which no options vest. For instance, with a one-year cliff, employees must remain with the company for at least one year before any options vest. If they leave before the one-year mark, they receive nothing. After the cliff period, vesting may occur gradually over time.

Cliffs help companies ensure that employees remain long enough to contribute meaningfully. However, a simpler solution might be to offer share options only after employees have passed their probation period, such as after a year of service. This straightforward approach can reduce complexity (and professional fees) while still protecting the company’s interests.

Common Vesting Structures

In practice, most companies, particularly in the tech industry, tend to adopt one of two common vesting structures:

1. Four or Five Year Vesting with a One-Year Cliff - After one year of service, 25% of the shares vest. The remaining 75% vest monthly, at a rate of 1/48th of the total grant, for the following three or four years. By the end of the time period, the employee's options are fully vested. This method is widely used by companies with a profit-making motive, as it encourages sustained contribution to the company's objectives over time.
2. Vesting on Exit - Here, options vest only upon the company's acquisition. Once the company is sold, employees exercise their options, convert them into shares, and immediately sell those shares to the acquirer at a profit. While they may need to purchase the shares, they’ll still benefit from the immediate sale. This structure is particularly useful for companies looking to incentivise employees to work towards an acquisition, or even a flotation on the stock market.?

Additional Considerations

• Accelerated Vesting: Some companies may offer accelerated vesting, where options vest more quickly if certain milestones, such as a company acquisition, are achieved. This can be an attractive incentive for employees during negotiations for a sale or other major events.
• Leaver Provisions: It’s also essential to consider what happens to unvested shares if an employee leaves the company. "Good leaver" and "bad leaver" provisions determine how many, if any, of the unvested options the employee retains.
• Tax Implications: Employees should also be aware of the tax implications of exercising options. In some countries, exercising share options triggers a taxable event, and the employee could owe tax on the difference between the option price and the market value of the shares at the time of exercise. For UK employees, the EMI scheme is typically used to minimise employee taxes.

In conclusion, designing a share option vesting scheme requires careful consideration of the company’s long-term objectives, the desired employee behaviour, and potential tax and legal implications. By choosing the right vesting structure, companies can align their employees’ interests with their own growth and success, ensuring that both parties benefit from the company’s future achievements.

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