Everything you need to know about vesting schedules

This article is for HR, people or finance teams that are looking for information on how to leverage vesting schedules, to ensure their equity plans work most effectively for the company. Firstly, we’ll cover the basics before leading on to some in-depth examples of how you or your business can utilise vesting schedules.

What is a vesting schedule?

A vesting schedule is a term used to describe a time period whereby benefits such as equity become available for employees to exercise. Usually, businesses that have ESOPs (employee stock ownership plans) set out a vesting schedule that incentivises employees to continue working for the business. For employees, this might mean that after each year of service you increase the amount of available shares/options. 

How does vesting work?

When an employee is offered a remuneration package, it can sometimes include a stock ownership plan that will have a vesting schedule. They are defined by the board and then used as an incentive for valuable employees to stay with the company. A typical vesting schedule could be over four years with a 12-month cliff, see our example below:

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The diagram above shows that during the first year of service, the employee does not gain the right to exercise any of their share options (this is known as the cliff). When the employee reaches the end of their first year, they jump to 25% vested and progressively move up to 100% vested at the end of year four.

This is not a one-size-fits-all approach. There are various types of vesting schedules and ways to adapt them, let's learn a little more about how to customise vesting schedules to fit your business needs.

Types of vesting schedules

Vesting schedules may have either time-based or performance-based conditions. Each of them have different implications for the recipient but also for the business.

Time-based vesting 

Linear vesting

Linear vesting describes a vesting schedule where shares vest equally over time. For example if you implemented an ESOP where there was no cliff, over the space of four years then 25% of the shares would vest in each year.

From a business perspective, a linear vesting schedule helps retain key talent for longer and reduces the risks associated with immediately awarding shares to an employee before they have proven their business impact. A vesting schedule that's easy to map, with equity being earned in regular increments, helps new hires and existing team members model their equity compensation over time.

Front-loaded and back-loaded vesting

Other variations of time-based vesting schedules include front-loaded and back-loaded vesting. Ultimately you can choose to award an employee with a higher rate of vesting initially, with progressively smaller increments vesting over time, or (with back-loaded vesting) start with smaller increments vesting that increase at a higher rate the longer the employee is in service. See our diagrams below:

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There are clear positives and negatives for both businesses and employees when implementing either front-loaded or back-loaded vesting schedules. When companies award a larger portion of the total equity grant earlier, as seen in front-loaded vesting schedules, the impact for employees is naturally positive but may lead to increased attrition once the bulk of an employee's equity stake has accrued in a relatively short period of time.

In contrast, the impact for companies of back-loaded vesting schedules is to minimise the equity outlay until employees have served significant time with the business. However, prospective new hires may not be attracted by the prospect of earning only a small percentage of their total grant in the first couple of years.

Reverse vesting

Reverse vesting occurs when shares devest at the same pace they originally vested if an employee were to leave the company. As a concept this is attractive for businesses, as they can essentially claw back vested shares from past employees over time. However, for employees, the prospect of losing equity once they leave the business is not attractive. For example, if an employee works for three years at the company before departing, without a trigger event that leads to a payout all of their previously vested shares would be lost three years after their resignation.

Performance-based vesting

Milestone vesting

Milestone vesting describes vesting schedules that give employees rights over their equity when they, or the business, hit pre-defined performance metrics or targets. An example of this concept would be an equity plan where 50% of an employee's allocated shares or options vest when the company's revenue surpasses £150m, with the next 50% vesting when revenue reaches £300m. These types of vesting schedule are more often designed for senior executives: it's rarer for more junior employees to have performance milestones dictating vesting.

Growth share schemes

Ledgy's guide to growth shares states that growth shares "are characterised by the use of a hurdle price, which lets growth shareholders benefit from an increasing share price beyond a pre-set hurdle, established by the company." Growth shares thus act as a kind of performance vesting condition, as employees' economic right to their equity is predicated on the share price reaching a certain level.

Typical vesting schedules – are you in line with market norms?

Ledgy platform data reveals that in general, all markets are coalescing around a standard vesting formula for employees’ equity: a four-year vesting period with a 12-month cliff. A four-year vesting period with a 12-month cliff is easy for employees to understand. It is also relatively simple to manage operationally compared to alternatives like performance-based vesting. Companies that adopt vesting ‘best practices’ stand to benefit from simpler equity plan administration and lower overhead for finance and legal teams. In addition, managers may see fewer questions and pushback from candidates or employees who could be expecting vesting that adheres to market standards.

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Accelerated vesting

Adhering to market norms to ensure you are maintaining a certain level of attractiveness to potential employees doesn’t end with just the vesting schedule. Vesting acceleration offers additional incentives for employees in the event of an exit. There are two main types of accelerated (or multi-trigger) vesting that companies often implement, which are single-trigger and double-trigger vesting.

Single-trigger vesting acceleration happens when an employee has worked for the business for a number of years but hasn’t yet reached the four year mark, whereby their shares would have fully vested. The business agrees to vest all of their remaining unvested shares if a particular event takes place, usually this would be when there is an exit. Single-trigger vesting acceleration is reasonably rare and would be perceived as highly valuable to employees.

The more common variation of accelerated vesting is double-trigger vesting acceleration. This is the same as single trigger vesting, however there is one additional event that must take place to trigger the accelerated vesting. The first trigger would still be in place, but the second trigger could be redundancy as part of a reorganisation during an exit event. Meaning the employee would benefit from accelerated vesting for any unvested shares if both triggers took place, providing them with full value if both of the trigger events take place.

Making the cliff work for you

The cliff, which is the initial 12 months in the market norm examples above, can be implemented in many ways. There is flexibility for the cliff to be shorter, longer or potentially not be used whatsoever. For example, when initially setting up a share scheme for employees, some may have already worked in the business for a few years. In this case it would be considered normal to not implement a cliff, as current employees would have already surpassed the potential cliff that would be standard for new employees.

How vesting conditions work on Ledgy

There are various different ways and reasons to adapt your vesting schedule to something that suits the needs of your company. Vesting conditions are commonly used, yet they can be complex to track effectively and implement at scale without the help of equity management software.

With Ledgy, it's easy to view, add or adapt different vesting conditions. From the main navigation panel you can click into the Vesting tab, you can then add performance or market conditions to vesting schedules, and decide whether or not to make those new vesting conditions visible to affected employees. 

Once you have set your vesting conditions, you can then manage, evaluate and publish them in the same tab within Ledgy. Employees will be able to view the target (if you enable this feature) in their dashboard, enabling them to track the progress and the outcome of the conditions.

In this example, the employee dashboard is reflecting the result of accelerated vesting due to the condition that was met. This is a great example of the visibility and communication enabled by Ledgy, which is key for businesses looking to encourage transparency around equity.

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