Employee Share Options: How Vesting Works and Why It Matters

Vesting is a mechanism that dictates how employees gain full ownership of their equity compensation over time or based on specific conditions. Rather than granting full benefits upfront, companies use vesting schedules to encourage long-term commitment and performance.

Choosing the right vesting structure depends on the company’s long-term strategy and growth trajectory. Here are the three most common approaches:

1. Time-Based Vesting

This is the most common vesting method, particularly for revenue-generating or cash-flow-positive companies. Employees earn their share options gradually over a set period, typically four to five years.

Example: A four-year vesting schedule with a one-year cliff means:

• No options vest in the first year (cliff period).
• 25% of the options vest after one year.
• The remaining 75% vest monthly over the next three years (1/48th per month).

This structure incentivizes employees to contribute to the company’s long-term success and build shareholder value.

2. Vesting on Exit

For startups targeting an acquisition or IPO, vesting on exit ensures employees are rewarded when the company reaches a liquidity event. In this scenario, options only vest upon a company sale or flotation. Employees then exercise their stock options, convert them into shares, and immediately sell them at a profit.

This model works well for early-stage startups investing in intellectual property (IP) rather than revenue generation.

3. Performance-Based Vesting

Some companies tie vesting to specific performance milestones, such as reaching a revenue target or valuation. While this approach directly links employee stock options to business growth, it comes with challenges:

• Defining and measuring valuation or revenue goals accurately.
• Addressing cases where targets are narrowly missed.
• Managing the complexity of implementation.

Due to these difficulties, performance-based vesting is less common and requires careful structuring.

A vesting cliff is the period before any options vest. For example, with a one-year cliff, employees must stay for a full year before receiving any vested shares. If they leave before this period, they forfeit their options.

An alternative approach is granting stock options only after an employee passes their probation period, simplifying administration and reducing legal costs.

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.

1. 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.

1. Accelerated Vesting

Some companies offer accelerated vesting, where share options vest faster under specific circumstances, such as an acquisition. This provides an extra incentive for employees during mergers or buyouts.

2. Leaver Provisions

It’s essential to define what happens to unvested shares if an employee leaves. Good leaver and bad leaver provisions dictate whether employees retain any of their unvested stock options upon departure.

3. Tax Implications

Employees should be aware of the tax impact of exercising stock options. In many countries, exercising options creates a taxable event, meaning employees could owe taxes on the difference between the option price and the market value of the shares.

For UK employees, the Enterprise Management Incentive (EMI) scheme helps minimize tax liabilities and maximize gains.

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.

If you would like some help with implementing your stock options scheme, then please get in touch with via LinkedIn or through our website.