If you're considering a new job or negotiating your employment contract, you may come across the term "cliff vesting." But what does it mean, and how does it affect your equity compensation?
This guide aims to explain what you need to know about cliff vesting, whether you're an employee about to accept a new job offer or a startup founder who's issuing stock options to retain employees on your startup team.
What is cliff vesting
Cliff vesting is a type of time-based vesting schedule used in employment contracts for equity compensations like stock options, restricted stock units, or performance shares. Under a cliff vesting schedule, an employee becomes fully vested in their shares or options after a specific period has elapsed.
Think of a cliff as the probation period which gives the company time to see how an employee performs, before they receive any equity. In the case of stock options, this means that an employee must remain with a company in order to start exercising.
How does cliff vesting work
Cliff vesting works by deferring an employee's entitlement to full benefits and equity compensation until they've completed a specific period of service, typically measured in years. During this period, the employee accrues equity rights that vest gradually over time, with a lump-sum payout at the end of the period.
This “cliff period” typically lasts between one and four years, depending on what's agreed upon by the employer and employee – but it can also be customized for individual employees or teams.
Once the cliff period is over, the employee (or founder) will start to vest their equity units on a predetermined schedule. This means that they can access their shares and any proceeds from the sale of those shares at regular intervals until the entire block of shares is fully vested.
Cliff vesting vs graded vesting
Graded vesting and cliff vesting are two types of time-based vesting schedules. While both types of vesting schedules require an employee to remain with a company for a certain period of time in order to fully earn their equity compensation, they differ in how that specified period of of time is structured.
In graded vesting, equity compensation is earned gradually over time, rather than all at once. For example, an employee might be granted stock options that vest at a rate of 25% per year over four years. This means that after the first year, the employee has earned the right to exercise 25% of their stock options, and after the second year, they have earned the right to exercise 50%, and so on, until they have earned the right to exercise all of their stock options after four years.
In cliff vesting, equity compensation does not vest at all until a specific length of time has passed. For example, an employee might be granted restricted stock units that vest after a one year cliff. This means that the employee does not earn any ownership rights to the stock units until they have been with the company for one full year. At the end of the one year cliff, all of the stock units vest at once, and the employee has full ownership of them.
Cliff vesting examples
To illustrate better, here are some cliff vesting examples:
1-year cliff vesting
An employee is granted 5,000 stock options as part of a job offer. The cliff vesting schedule is 1-year cliff vesting plan – meaning the employee won't receive any equity until they have worked at the company for an entire year.
After one year of service, the employee can now exercise their 5,000 stock options and become a shareholder in the company.
3-year cliff vesting
Similarly, if the agreement states 3-year cliff vesting period, it means the employee will not have access to their stock options until 3 years of service have been completed. Only when the employee reaches the 3-year mark can they access the equity in one lump sum (in the case of stock units) or begin exercising his options (in the case of stock options).
Getting the drift? Let's keep going.
4-year cliff vesting
If the agreement states 4-year cliff vesting, then this means the employee can't access his equity until their 4-year mark at the company.
While this is a possible vesting agreement, it may not be the best vesting agreement if your goal is to attract today's young generation of talents. Studies show that millennials and gen-z workers have a tendency to job-hop and spend less than 3 years in a job. It's important to take factors like this into consideration when deciding vesting conditions for valuable employees at your startup.
With that said, the most common type of vesting condition is a combination of cliff vesting and graded vesting. Specifically, the 4-year vest, 1 year cliff.
4-year vesting with 1-year cliff
4-year vesting with 1-year cliff is a common vesting conditions when it comes to employee stock option plans or equity agreements.
In this scenario, the vesting period has a duration of 4 years, which means that the employee's stock options will become fully vested after 4 years of service with the company. The "1-year cliff" refers to the initial period where the employee has to stay for a year before their stock options begin to the four year vesting period.
After the cliff period, vesting typically occurs on a pro-rata basis, meaning that a percentage of the equity would vest gradually over time.
In this example, if an employee was granted 1,000 stock options that are subject to 4-year vesting 1-year cliff, 25% of their shares would vest after the first year (250 shares). The remaining 75% would vest gradually over the next three years (250 shares each year).
If an employee leaves before this period ends, he walks away without anything and the unvested options would be returned to the option pool.
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Pros and cons of cliff vesting
Here are some of the yummy and not-so-yummy aspects of cliff vesting for you to appreciate:
Advantages of cliff vesting
- Flexible. Cliff vesting gives founders and startups the flexibility to decide when they want their employees to receive their total equity.
- Low risk. When you use cliff vesting, employers do not have to worry about employees leaving too quickly after receiving partial equity distributions.
- Incentivizing loyalty. By waiting until a certain period of time has passed before awarding total equity, cliff vesting encourages employees to remain loyal and devoted throughout their tenure at the company.
- Cost-Effective. This type of vesting allows companies to save money upfront as they do not need to pay out large sums of money for employee shares until the predetermined date.
- Motivates employees. A cliff vesting schedule is a great motivator for employees to stay with the company and work hard, as they know that their full equity will be available at the end of the cliff.
Disadvantages of cliff vesting
- Can cause a lack of motivation for employees. If an employee has to wait until the end of their vesting cliff period to receive all of their equity, they may not be as motivated to stick around, especially if they have a chance at other opportunities.
- Loss of bargaining power. If you don’t have the option to negotiate your cliff vesting schedule, then you won’t be able to get more stock upfront or potentially increase the rate at which your equity vests.
- Missed opportunity cost. Depending on your vesting cliff length, you could miss out on potential upside should the company experience success during the vesting period.
The solution to counter most of the less desirable effects of cliff vesting is to combine cliff vesting with graded vesting; you’ll offer your employees the best of both worlds and show you’re a great place to work!
Frequently asked questions about cliff vesting
What happens if I leave the company before the cliff period ends?
If you leave the company before the cliff period ends, you'll forfeit your right to any unvested equity compensation. However, you'll still own any vested equity compensation.
Can cliff vesting schedules vary in length?
Yes, cliff vesting schedules can vary in length, depending on the company's policies and the type of equity compensation being granted.
How does cliff vesting differ from other types of vesting schedules?
Cliff vesting differs from other types of vesting schedules, such as graded vesting, in that all equity compensation is vested at once, rather than gradually over time.