A complete guide to share vesting and how vesting work benefits employees and employers

Share vesting is an essential concept for both employees and employers in startups and growing businesses. It allows employees to earn company shares over time, encouraging long-term commitment. This arrangement aligns the interests of employees and employers. Understanding how share vesting works can help businesses build a motivated workforce while offering employees valuable ownership opportunities.

A quick guide to share vesting

Share vesting is a process where employees earn ownership of company shares over time. It encourages long-term commitment and aligns the interests of employees and employers. Vesting schedules and milestones determine when shares become fully owned. This arrangement benefits both employees, who can gain from share growth, and employers, who retain talent.[ez-toc]

What is share vesting and why does it matter?

Share vesting is the process where an individual gains ownership of shares over time, instead of receiving full ownership immediately. This ensures that employees or founders remain with the company for a certain period and contribute to its growth.For startups and businesses, share vesting serves several key purposes. It allows companies to offer equity as a form of compensation, which can be especially valuable when cash is limited. By providing equity, businesses attract talent without the immediate financial burden. Vesting is particularly important in startups, where stock options or shares can be a significant part of an employee’s compensation package.Vesting incentivises employees and co-founders by aligning their goals with the company's long-term success. When employees receive shares, but those shares vest over time, they are motivated to stay with the company and contribute to its growth. For example, a co-founder may receive shares that vest over four years, encouraging them to stay and continue working towards the company’s success. Similarly, stock options or RSUs (restricted stock units) can motivate employees to perform well, as they know they will gain full rights to their shares over time.Moreover, vesting helps retain top talent. If an employee leaves before their shares vest, they forfeit unvested shares. This ensures that only those who contribute long-term to the company’s success truly benefit from equity compensation. Essentially, share vesting rewards commitment, incentivises growth, and encourages employees to stay longer at the company.Through vesting, companies effectively "earn" their equity compensation over a specific period or upon achieving certain milestones, making it a powerful tool for long-term business success.

How does the vesting process work?

The vesting process is a way for employees or co-founders to earn ownership of shares over time. Instead of getting full ownership immediately, the shares "vest" gradually, giving the individual the right to claim more shares as time passes. This process ensures that people stay with the company and contribute to its success.

Vesting schedule and vesting period

A vesting schedule outlines when and how shares will vest. It’s a plan that sets the pace of the vesting process. For example, if someone is given 100 shares with a four-year vesting schedule, they will receive a portion of those shares every year over the four years. The vesting period refers to the total time it takes for shares to vest fully.Most common schedules include:

• Annual vesting: Shares vest evenly over a set number of years.
• Monthly vesting: Shares vest monthly, often after a cliff period.
• Cliff vesting: This means shares vest all at once after a certain period, such as one year.

Vested shares vs unvested shares

Vested shares are shares that the employee or co-founder fully owns. They can sell or transfer these shares if they choose. Unvested shares are shares the individual doesn’t yet fully own. They cannot sell, transfer, or exercise rights over these shares until they vest.

How shares are transferred once vested

Once shares are fully vested, the employee gains full rights to them. This means they can sell or transfer the shares as they wish. The company will typically update its records to reflect this transfer. For example, if shares are part of an equity compensation package, the employee may now have the right to sell the shares or hold onto them for future potential growth.Vesting ensures that employees earn their shares by staying with the company and contributing to its success.

The different types of vesting schemes

There are different types of vesting schemes, each with its own benefits and structure. These schemes determine how and when employees or co-founders earn their shares. The three most common types of vesting schemes are cliff vesting, graded vesting, and hybrid vesting. Each works in a slightly different way.

Cliff vesting

Cliff vesting is a simple structure where an employee or co-founder does not receive any shares until they reach a specific milestone, usually a set time period, such as one year. After that point, all the shares become vested at once.For example, an employee might have 100 shares with a one-year cliff. After the first year, they gain full ownership of all 100 shares. This scheme is often used in startups where businesses want to ensure employees stay for a minimum period before earning any shares.

Graded vesting

In graded vesting, shares are vested gradually over time. For instance, an employee might earn 25% of their shares each year over four years. This type of vesting offers a steady reward for staying with the company and contributing over time.A typical graded vesting structure might look like this:

• 25% after one year
• 25% after two years
• 25% after three years
• 25% after four years

Hybrid vesting

Hybrid vesting is a combination of both cliff and graded vesting. The employee may receive some shares after a cliff period, and then continue to earn the remaining shares gradually. This scheme offers flexibility and helps businesses balance immediate incentives with long-term retention.For example, an employee might receive 50% of their shares after a one-year cliff, and the remaining 50% could vest over the next three years on a graded schedule.

Which scheme is best?

• For startups: Cliff vesting works well for startups. It encourages employees to stay at least one year before receiving shares, which helps the business manage cash flow in the early stages.
• For employees: Graded vesting provides a more predictable path to earning shares. It’s good for employees who want a steady increase in ownership.
• For employers: Hybrid vesting offers the best of both worlds. It rewards employees upfront and incentivises long-term commitment.

Each scheme has its place, and choosing the right one depends on the needs of both the business and the employees.

Vesting schedule and milestones: Key components to consider

A vesting schedule is a timeline that determines when an employee or co-founder will earn full ownership of their shares. It is a crucial component of any vesting agreement, as it ensures employees stay with the company long enough to realise the value of their equity.

Why is the vesting schedule important?

The vesting schedule encourages long-term commitment by tying ownership to time or specific milestones. Without it, employees might leave early and take their shares without contributing fully to the company’s growth. The schedule can vary depending on the company’s needs, the employee’s role, and other factors.A typical vesting schedule spans several years. The most common schedules are time-based or milestone-based.

• Time-based vesting: Shares vest gradually over a set period, such as four years.
• Milestone-based vesting: Shares vest when specific company or individual goals are met, like achieving sales targets or reaching development milestones.

The role of milestones in vesting

Milestones are specific goals that must be achieved for shares to vest. These can be tied to performance targets, company growth, or individual achievements. For example, an employee might need to help secure a major contract or launch a new product before their shares vest. Milestones align the interests of the employee with the success of the company.Milestone-based vesting encourages employees to work towards specific company goals, making them feel like part of the company’s growth. It helps businesses keep top talent engaged and motivated to meet targets.

Sample vesting schedule with milestones

Here is an example of a vesting schedule with milestones:YearVesting PercentageMilestone Achieved125%Achieve revenue target225%Complete product launch325%Secure partnership deal425%Lead expansion to new marketThis example shows how shares can vest gradually over time, while also rewarding specific achievements.By combining time-based and milestone-based vesting, companies can create a more flexible and motivating structure for their employees.

How long is the typical vesting period?

The vesting period is the time an employee or co-founder needs to stay with a company before fully owning their shares. It is a key part of the vesting process, ensuring that employees remain committed to the company's long-term success.

Standard vesting period in startups and companies

The most common vesting period for startups and established companies is four years. This means employees or co-founders usually need to stay with the company for four years before they earn full rights to their shares. A common structure is a four-year period with a one-year cliff. The cliff means that no shares vest until the employee has been with the company for a full year. After that, the shares vest gradually over the remaining three years.In larger companies, the vesting period can sometimes be longer, typically five years. This is often used in more stable industries where long-term retention of employees is a priority.

Factors that affect vesting period length

The length of the vesting period can depend on several factors:

• Company size: Larger companies may offer longer vesting periods to ensure employees remain committed to the company for a significant time.
• Industry norms: Some industries, like tech or finance, may follow standard four-year vesting periods, while others may differ.
• Employee role: Key employees or co-founders may have a more customised vesting period depending on their level of involvement or importance to the company’s growth.

Examples of typical vesting periods in different industries

Here are examples of typical vesting periods for various industries:IndustryTypical Vesting PeriodStartups4 years (with a 1-year cliff)Technology4-5 yearsFinance5 yearsLarge Corporations4-5 yearsThe vesting period can vary based on these factors, but the standard is usually between four and five years.

Share vesting agreements: What’s included?

A share vesting agreement is a legal document that outlines the terms and conditions of share vesting. It helps ensure both the company and employee are clear on how and when shares will be earned and owned.

Key elements of a share vesting agreement

A well-structured share vesting agreement will include several key elements:

• Vesting cliff: This is the point in time when shares first begin to vest. It’s typically set to a one-year period. If the employee leaves before the cliff ends, they will not earn any shares.
• Vesting period: This is the length of time over which shares will gradually vest. The most common vesting period is four years, with shares vesting incrementally over that period.
• Milestones: Some agreements may tie the vesting of shares to specific milestones. These milestones could be related to company growth, performance targets, or other important achievements.

How agreements align expectations and prevent disputes

A share vesting agreement aligns the expectations of both the employer and the employee. It clearly defines how long the employee needs to stay with the company to earn full ownership of their shares. This clarity helps avoid misunderstandings or disputes later on.For example, the agreement may outline that the employee will receive a specific number of shares over four years, with the first 25% vesting at the end of the first year (the cliff), and the remaining shares vesting quarterly after that.

Example of key points to include in a share vesting agreement

• Number of shares to be granted and how they will be vested.
• Vesting cliff: When shares start vesting (e.g., after 12 months).
• Vesting schedule: The exact timeline of when shares will be vested.
• Milestone-based vesting: Specific targets or achievements tied to share vesting.
• Conditions for termination: What happens if the employee leaves or is terminated.
• Tax implications: Clarification of any tax obligations related to the shares.

Including these points in the share vesting agreement will protect both the employee and the employer and ensure that the vesting process is clear and fair.

What are the benefits of a share vesting scheme for employees and employers?

A share vesting scheme offers several benefits for both employees and employers. It encourages long-term commitment, motivates performance, and aligns the interests of both parties. Here's how it works for each side.

Benefits for employees

• Aligning interests with company success: Share vesting ensures that employees have a stake in the company’s growth. The more successful the company is, the more the employee’s shares will be worth. This makes employees more invested in the company's performance.
• Encouraging long-term commitment: By tying shares to a vesting schedule, employees are motivated to stay with the company longer. The longer they remain, the more shares they earn. This reduces the likelihood of frequent turnover.
• Potential for wealth creation through dividends and share growth: As the company grows, the value of its shares can increase. Employees who hold vested shares may benefit from dividends or increased share value over time. This creates a long-term financial benefit for employees who remain with the company.

Benefits for employers

• Retaining talent and reducing turnover: A share vesting scheme helps employers retain key employees. Since shares vest over time, employees are less likely to leave the company, knowing that they will forfeit unvested shares if they do.
• Motivating employees to reach company goals: When employees have a personal financial interest in the company’s success, they are more motivated to work towards its goals. This can lead to increased productivity and a better overall performance.
• Enhancing company culture and ownership: By offering shares, employers can foster a culture of ownership. Employees feel more connected to the company’s mission and goals, improving morale and collaboration across teams.

In conclusion, a well-structured share vesting scheme benefits both employees and employers. It creates a mutually beneficial environment that encourages growth, commitment, and success for everyone involved.

How can startups use share vesting to incentivise employees?

Startups face unique challenges when it comes to attracting and retaining talent. Often, they can’t offer high salaries or extensive benefits, but share vesting provides a valuable way to compensate employees and keep them motivated.

The role of share vesting in startup environments

In a startup, cash flow can be limited. Offering equity through share vesting allows startups to reward employees without draining resources. This approach helps align employees’ interests with the company's success. As the company grows, the value of the shares increases, which benefits the employees.

How startups use vesting to attract and retain key talent without high salaries

Startups can use share vesting to offer equity as part of their compensation packages. Employees are more likely to stay if they see the potential for future wealth through the company's success. Even without high salaries, the promise of vested shares over time makes the job more attractive. The longer the employee stays, the more shares they earn.

Examples of vesting plans that motivate employees

• Time-based vesting: Employees earn their shares over a set period, often 3–4 years. This encourages long-term commitment and reduces turnover.
• Milestone-based vesting: Shares are earned once specific targets, such as product launches or revenue goals, are met. This motivates employees to contribute towards achieving company milestones.

Balancing salary and equity in startup compensation

In a startup, the challenge is to balance salary with equity. Some employees may prefer higher salaries over equity. However, offering a smaller salary with a larger equity stake can help align the employee’s interests with the company's growth. This balance encourages employees to stay longer and work harder, knowing they will benefit from the startup's success.In summary, share vesting is a powerful tool for startups to incentivise employees, attract top talent, and foster long-term growth. By offering equity, startups can create a committed workforce that is motivated to drive the company forward.

What happens when shares are vested?

Once shares are fully vested, employees gain ownership rights to those shares. This means they have the right to sell, transfer, or hold the shares as they see fit. However, there are several things employees need to consider once their shares are vested.

The process once shares are fully vested

When shares vest, employees officially own the shares. This means they no longer have to meet any future conditions or time-based requirements to keep them. The shares are theirs to keep, sell, or transfer. The employer typically notifies employees once their shares have vested.

How employees can sell or transfer vested shares

Once shares are vested, employees are allowed to sell or transfer them. However, if the company is private, employees may face restrictions on selling shares. For example, the company may require approval for any sale or transfer of shares. In public companies, employees can usually sell their shares on the stock exchange once they are vested. The company may also have a set period during which employees must hold the shares before selling.

Tax liabilities and other considerations

Employees must also consider the tax implications of selling vested shares. The profit made from selling the shares is often taxed as capital gains. In some cases, employees may need to pay taxes at the time the shares vest, depending on the type of share plan. It’s important to understand these tax responsibilities and consult with a tax advisor to ensure compliance.

Handling dividends once shares are vested

After shares are vested, employees may be entitled to dividends if the company declares them. Dividends are a portion of the company’s earnings paid to shareholders. The amount received depends on the number of shares held. Employees who hold vested shares are entitled to these dividends, just like any other shareholder.In summary, once shares are vested, employees gain full ownership and control over them. They can sell, transfer, or keep the shares, but should consider tax liabilities and any company-specific restrictions.

Key considerations and risks in share vesting

Share vesting can benefit both employees and employers. However, there are several risks and challenges that both parties should consider. By understanding these risks, businesses and employees can make informed decisions and mitigate potential problems.

Risks for employees

1. Leaving before shares are vestedOne of the main risks for employees is leaving the company before their shares are fully vested. If an employee leaves early, they may forfeit any unvested shares. This can be particularly impactful in long vesting periods where only a portion of the shares have vested.
2. Changes in company ownership affecting vesting termsChanges in a company’s ownership, such as mergers, acquisitions, or buyouts, can affect the vesting terms. Employees might lose their vested or unvested shares depending on the structure of the deal. It's important for employees to understand how these changes can impact their share ownership.

Risks for employers

1. Employee dissatisfaction with vesting schemesIf employees feel that the vesting scheme is unfair or not aligned with their goals, they may become dissatisfied. This can lead to lower morale and even increased turnover. Employers should ensure the scheme is transparent and equitable.
2. Legal and compliance issues in vesting agreementsEmployers must be careful when creating share vesting agreements. There are legal and regulatory requirements that must be followed. Failing to comply with these rules can result in penalties or legal disputes. Employers should work with legal experts to ensure the agreement is clear and compliant with relevant laws.

Tips for mitigating risks

1. Clear agreementsTo avoid misunderstandings, both employees and employers should ensure that the terms of the share vesting agreement are clearly outlined. This includes vesting schedules, milestones, and conditions for forfeiture.
2. Regular reviewsEmployers should regularly review and update vesting agreements. This ensures that the agreement stays relevant and fair, particularly in cases of company changes or evolving employee roles.

By understanding these risks and implementing clear agreements, both employees and employers can make share vesting work in their favour.

How to set up a share vesting agreement for your business

Setting up a share vesting agreement is crucial for aligning the interests of both employees and the company. A clear vesting scheme can help retain talent and ensure that employees are motivated to work towards the company’s long-term success.

Step-by-step guide to setting up a vesting scheme

1. Define your goalsStart by identifying what you want to achieve with the vesting scheme. Are you aiming to retain employees for a certain period? Do you want to reward performance milestones? Your goals will help shape the type of vesting scheme you choose.
2. Choose a vesting scheduleSelect a vesting schedule that aligns with your company’s goals. Will you use time-based vesting, where employees earn shares over a set period? Or will you use milestone-based vesting, where shares vest when certain company or individual performance goals are met?
3. Set the vesting periodDecide on the length of the vesting period. A common choice is a four-year vesting period, often with a one-year cliff. This means employees must stay for one year before any shares vest, after which the remaining shares vest over the following three years.
4. Determine vesting milestonesIf using milestone-based vesting, set clear and achievable milestones. These could include performance targets, company growth, or project completion. Ensure that these milestones are specific and measurable.
5. Include key terms in the agreementClearly outline the terms of the agreement, including the vesting schedule, milestones, vesting cliff (if applicable), and any conditions for forfeiture. This should also cover what happens if an employee leaves before their shares are fully vested.

Legal and financial considerations

• Legal requirementsWhen drafting a share vesting agreement, ensure it complies with all relevant laws and regulations. This may include tax laws, employment laws, and securities regulations.
• Tax implicationsVesting shares may have tax implications for both the company and the employee. Be aware of the tax treatment of vested and unvested shares.

How to choose between different vesting schedules

• Time-based vestingThis is the most straightforward option. Employees earn shares over a fixed period, such as four years, with a set number of shares vested each year.
• Milestone-based vestingShares vest when certain company or individual milestones are achieved. This is often used in high-growth companies where performance is tied to equity.
• Hybrid vestingThis combines both time-based and milestone-based vesting. Employees earn shares over time, but only if certain milestones are met.

Importance of consulting with a legal advisor

A legal advisor is essential when setting up a share vesting agreement. They will ensure that the agreement is legally sound and compliant with tax and employment laws. Consulting with an expert can also help avoid common pitfalls, such as unclear terms or non-compliance with tax rules. A qualified legal advisor can provide guidance on the best structure for your business and help draft an agreement that protects both the company and its employees.In summary, a well-structured share vesting agreement aligns the interests of employees and employers. By following these steps and consulting with legal professionals, you can create a fair and effective scheme that drives long-term success.If you would like a free consultation for legal advice you can contact Legal Kitz.

FAQ about share vesting

What is share vesting and how does it work?

Share vesting is the process where employees earn the right to own company shares over time. They do not own the shares immediately. The shares are "vested" gradually through a vesting period, usually tied to a specific period of time or milestones. Once vested, employees have full rights to the shares and may sell or exercise them.

What is a vesting cliff?

A vesting cliff is a type of vesting scheme. Employees must stay with the company for a certain period of time before any shares are vested. After this period, they may receive a lump sum of shares all at once. This usually happens in the first year of employment.

How long does the vesting period last?

The vesting period typically lasts over several years. A common vesting schedule is four years. However, some companies may have shorter or longer periods, depending on their goals. At the end of the vesting period, employees may have full rights to their shares. You may need to wait for this period to pass before receiving your full allocation of shares.

Can an employee sell vested shares before they are fully vested?

No. Employees can only sell or transfer shares once they are fully vested. If shares are unvested, the employee does not have ownership rights to them. Even if the shares are partially vested, they cannot be sold or exercised. For example, RSUs (restricted stock units) are not transferable until they have vested.

What happens if an employee leaves before the vesting period ends?

If an employee leaves before the end of the vesting period, they typically lose the unvested shares. In some cases, they may retain the vested options, but not the unvested ones. Employers may also have specific terms in place in case a co-founder leaves. A clear agreement will help clarify what happens when this occurs.

What is the role of legal advice in share vesting agreements?

Legal advice is crucial when creating a share vesting agreement. Expert lawyers or a qualified professional can ensure the agreement is clear and legally binding. This helps avoid disputes and ensures both parties are protected during the vesting process. They can also advise on tax implications, rights to shares, and vesting schemes for private companies.

How do milestones affect share vesting?

Certain milestones may be added to the vesting process. For example, if employees meet performance targets or company growth milestones, they may receive additional shares. This is known as milestone-based vesting. It adds another layer of motivation for employees to stay and work towards company goals.

How does share vesting benefit employees?

Share vesting allows employees to gradually earn ownership in the company. It provides long-term incentives and the potential to grow wealth. The employee will earn an asset over time. The process encourages employees to stay longer at the company and be more involved in its growth. It also helps employees become owners, which gives them a direct stake in the company’s success.

How does share vesting benefit employers?

Share vesting helps employers retain talent by aligning employees' goals with company growth. By offering partial ownership, employees are more likely to stay longer and work harder. This reduces turnover and promotes a culture of commitment. Vesting also encourages employees to help grow your business, as their success is tied to the company's success.

How can a company choose the right vesting schedule?

A company must consider various factors when choosing a vesting schedule. Some companies prefer a combination of time-based and milestone-based vesting. This can motivate employees to reach specific milestones while still rewarding them for long-term commitment. Consulting with a qualified professional can help companies decide the best approach for their business and employees.

Final thoughts on share vesting

Share vesting is a powerful tool for businesses to attract and retain talent. It aligns the interests of employees and employers, fostering long-term commitment and growth. By offering equity in the company, businesses can provide employees with a sense of ownership, motivating them to work towards shared goals.For employees, vesting offers the potential for wealth creation, while giving them security as they contribute to the company’s success. For employers, it helps to reduce turnover and create a culture of ownership.Whether you’re setting up a share vesting agreement or considering how it can benefit your business, it’s important to understand the different vesting types, schedules, and key considerations. Consulting with a qualified legal advisor ensures that the agreement is clear and legally sound.Ultimately, share vesting can be a win-win for both employees and employers when set up properly.

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