What is an effective vesting schedule for equity compensation?

From a recruitment perspective and having experience working in high growth startups, offering equity to the best talent in order to incentivize workers requires you to compete with other startups for the same talent. The failure rate for those startups can be high so requiring 4 or more years to fully vest doesn’t allow you to compete for the best and brightest. The most promising and aggressive startups are offering 24-36 month vesting periods with a one year cliff vesting quarterly after 12 months. The dollar amounts are also fairly rich dependent upon the impact of the role. Anything beyond 4 years isn’t competitive especially considering how often startups layoff employees in this climate.

The most common is a 4 year vest with one year cliff which is time based. A second type is based on a financial event such as an ipo, merger or another type of milestone. A third type of vesting schedule is a combination of time based and financial event which is referred to as a double trigger. It’s also important to understand the tax implications for RSU (Restricted Stock Units) vesting and exercising NSOs(non-qualified stock options) and ISOs(incentive stock options).

Cliff: The employee doesn't receive any shares or options until they have completed one year of service with the company. At the one-year mark, they become vested for 25% of the total grant.

I think ideally the vesting should start only from year three - which means you have worked for two years before you can vest. This is important because in most cases, you start providing most value only in your second year

The vesting schedule depends upon your company priorities and strategy. In tech the vesting schedule is 4 years with installment vesting. In most other more matures industries it is 3 years with cliff vesting. Ultimately you have to balance reward employees with company objectives

First, a well defined vesting schedule will set the employer and the employee on the same page from day one. Thus, future conflicts will be prevented. For the employee, having a definite vesting schedule helps him/her to assess its net impact on their long term career goals and their expected future wealth with some certainty. Further, the employee can always reassess how likely it is that the initially assessed net benefits of the equity-based compensation will accrue to them at the end of the vesting schedule considering prevailing economic and financial events.

Taxes are wild, specially in India where ESOPs could be taxed at 35 to 40 percent in the hands of employee. I have seen employees not feeling well about paying taxes before even getting the shares in demat. In some cases they have to take short term high interest bank loan to repay taxes arising on vesting of ESOPs, in general, they don't feel good about it. I have seen in one case founder himself lent money to employee for paying his taxes. One should appropriately weighs in the tax outgo.

A vesting schedule serves multiple purposes but the best is employee retention. If an employee has a certain amount of income they will lose by leaving they have more motivation to stay and help contribute to the overall success of the company. IT works well for the company too if the employee doesn't work out they have held back part of their compensation.

I second the view that there is no one-size-fits-all formula for negotiating an effective vesting schedule. Longer vesting period may helps when the growth prospect of company are multifold. However, people likes certainity. In general employees rush to liquidate ESOPs soon after exceerrsing, they bet for shortest vesting period. However, employer want to retain their talent for the longest period. The answer lies somewhere in between.

Negotiating an equity-based compensation usually involves the employee assessing the impact of the offer on their long term goals and how competitive the offer is, compared to industry standard. Some, vesting schedule have a pleated to offer high benefits in the short term with their value eroding in the longer term and vice versa. Should the staff possess very relevant and highly-demand but scarce technical skills, he/she can leverage on its the benefit of those skills to the company and request for a better arrangement. However, like in all negotiations, the employee has to be tactful and present a convincing demand.

For employees, equity-based compensation arrangements is one effective way of buying into the future success of a company. For the shareholders, it is one way of aligning the employee's goals to the shareholders' wealth maximization objective. Provided, employees can see the arrangement as beneficial, the company will have lower staff turnover which adds to ensuring the long-term stability in the operation of the company.