Revisiting the Vesting Schedule
Jul 17th, 2015
Silicon Valley gave birth to (among many other things) the practice of granting employees equity as part of their compensation package. This practice began nearly fifty years ago with the spawn of companies like Hewlett-Packard. However, the terms of earning your equity over time have remained largely unchanged. Today we want to revisit the nearly universal “4 year vest with a 1 year cliff.” This common vesting schedule means that you earn your equity grant evenly over 4 years, except none of it is yours until you’ve passed your one year mark.
A lot has changed in Silicon Valley and beyond over the years. Let’s take a look at why this vesting schedule exists, what’s changed, and how it has been impacted.
According to the National Venture Capital Association, the median time to IPO was 3.1 years in 2000. Employees were granted equity that would vest until the company would go public, or even beyond that date – 4 years from when the employee started. Employees’ incentives and timeline were tied to that of the company. There were no (or perhaps very limited) issues of employees struggling to afford their exercise or pay AMT taxes. Publicly traded stocks make a cashless exercise a no-brainer and lower valuations while companies were still private kept exercise costs within reason. This vesting schedule seemed to work pretty well.
Venture backed companies are now waiting longer to go public. That median time to IPO of 3.1 years swelled to 7.5 years by 2013. A longer discussion on why that is the case here, but the data says a lot. Not only does the 4-year vesting schedule not line up with the time to exit but other problems have been created in the process:
- Companies now must give additional grants to retain employees after their initial 4 years are up. This can cause attrition if not handled properly.
- Equity vests over 4 years, but the options expire within just 90 days of leaving the company.
- As companies stay private longer, their valuations balloon in the private markets (ahem, Uber is worth $50 Billion?)
- The strike price on grants continues to increase as the private market valuation increases. In many late stage companies, employees simply can’t afford to exercise all of their options, let alone pay the subsequent tax bill.
So what should we do?
Firstly, companies' and employees' incentives need to be aligned. Employees are awarded equity as compensation so that they may work hard to build that into something meaningful. A four-year horizon doesn’t quite line up with that anymore. Company’s can offer new grants, but the employee who took a risk joining a smaller company 4 years ago is forced to pay significantly higher price to own those new options. Or by the time they receive a new grant they may be considering other paths. Some thoughts to consider: Should the vesting schedule be lengthened? Should one vest relative to how early on they joined? Should they be able to lock in a lower exercise price at the beginning?
Secondly, with private company valuations soaring as they stay private longer, many employees can’t afford the cost to exercise their options or pay their AMT Tax bill. This has forced many employees to leave their options on the table if they move to another company. Options they were given to reward and in exchange for their hard work. Things to consider: Should employees have the right to a cashless exercise? Should the expiration window be extended well beyond the current 90-day mark (such as Pinterest has done)? Should Options be worthless until they are sold and given value?
Companies are staying private much longer and are worth much more while private. More and more people are leaving high paying professions to help build small companies. I think we’ll start to see new alternatives as companies and employees navigate this changing landscape. There isn't yet one standard solution. What does need to be maintained on either side of the equation is:
1) Employee incentives should be tied to those of the company
2) Employees have the right to access the equity--and its underlying value--they are rewarded
* * * * *
A few interesting opinions on the subject:
- Sam Altman of Y Combinator offers up some interesting ideas to this in his blog on Employee Equity. Among them are forward dating grants to obtain lower strike prices and weighting grants to vest more the longer you stay.
- Wealthfront takes a more conservative approach, opting to stick to the 4 year vest and 1 year cliff. More on their thoughts here and here.
- A VCs view to keep it simple and adapt the old model to today by lengthening the vesting period.