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What does vesting period mean and why is so important for equity compensation

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Why are Vesting Rules Important

When you hear someone talking about all the important things to remember when offering and designing an equity compensation plan for your company, you’ll probably hear a lot of jargon-filled advice, going through a long list of features. And it’s true, there are a lot of things to remember.

You need to use a plan that best suits your company and employees, you need to balance the benefits to you of a long-term plan with the desirability of joining the plan, and you need to make sure you’re offering the right amount of equity.

But if we could offer one piece of advice, the most important advice we can give, it’s to implement vesting rules.

Vesting rules are one of the most important parts of your equity compensation plan. This particularly applies to startups and SMEs, who are just starting out – but it applies to larger companies as well.

Let’s take a look at what vesting rules are, and why they’re so important.

What does Vesting shares Period mean?

When a share (grant or award) has a vesting period, the recipient must wait a certain amount of time before they actually own the grant or award. When the vesting period has passed, the recipient is the owner and can exercise or sell the shares.

For example, what does it mean for an award to vest? It means that the award actually belongs to the recipient now. If your options have a vesting period of 3 years, you need to wait 3 years before you can exercise or sell them.

Vesting Criteria

There are two types of vesting periods, cliff vesting and graduated vesting.

Imagine a company offers you an award of 100 shares, with a vesting period of one year. This means that they will grant you the award, but you cannot do anything with the shares (sell them, etc.) until one year later. After a year, they’re yours – they have vested.

That’s a common type of vesting known as cliff vesting.

In graduated vesting (also known as ratable or graded), part of the award vests –become available – in intervals.

For example, if a company offered you an award of 300 shares, with a graduated vesting period of three years, then after your first year you would receive 100 shares. The next year, 100 shares, and 100 shares the next year.

There are, of course, advantages and disadvantages to both. It depends on what your company needs, and what is best suited for your industry and jurisdiction.

Why Vesting Rules are important for SMEs?

Establishing vesting rules for your equity compensation – and getting them right – is vitally important. Vesting rules are a great incentive for employees to remain with the company for a longer period of time.

Just make sure you balance the benefits to your company with the attractiveness of joining the plan for employees.

A cliff vesting with a long-term vesting period of three or five years might sound attractive for the business. But realistically, a bonus five years in the distance – no matter how big a bonus – is not likely to influence behavior. But a cliff vesting period of one year, or a graduated vesting period of three years, can keep employees not only with the company but motivated as well.

Why Vesting Rules are important for Startups?

Vesting rules are important for SMEs, but they are crucial for startups. They prevent you from giving away too much of your equity, and when you’re a startup, any little bit of your equity you give away without significant return is catastrophic.

Imagine a startup with two founders and three employees. They have split the equity with each founder owning 35% of the company, and the employees owning 10% each.

There are no vesting rules, so as soon as the employees joined, they received their full equity, just as the founders already had all their equity.

Then, one day, a founder leaves. And maybe she takes one of the employees with her, to start up a new company.

Can you see the problem?

45% of the company has just walked away, taking every single one of those percentage points with them. There’s nothing the company can do – from now on, those leavers don’t need to do anything, and they will receive 45% of the rewards. Not only that, but the startup now has 45% less equity for investors and future employees.

The startup is no longer a start-up, it’s a close-down.

Now, that was just an illustration – but it drives home the essential point.

No matter how great your leadership, or how amazing your employees are, you are going to have people leave. It’s inevitable. And your equity is the most valuable thing you have – if you let it walk out the door with those leavers, your business will most likely not recover.

On the other hand, your employees need something to aim for, and to motivate them, and they need to be fairly rewarded. So, you need to balance these two. And you do it with vesting rules. If that founder and employee had graduated vesting, for example, they would have left with significantly less equity – enough to reward them for the work they had done, and no more.

How we can help

Here at Global Shares, we know the most important advice for companies looking to launch their own equity compensation plans because we’ve helped so many to do it.

Our purpose-built platform helps to streamline the entire equity administration process, including managing different types of vesting periods. Through the Global Shares platform, you can easily track and automate all of your employee vesting schedules from one secure place, meaning less time is spent on administration and managing messy spreadsheets.

From startups to public companies, we can help.

If you’re looking to learn more about equity compensation, check out our Equity Explained series. Whether you’re completely new to equity compensation or looking to improve your knowledge, we have a curated library of resources to help you learn all about the world of employee ownership.

If want to make sure your equity is in good hands, contact us for a free demo today.

Please Note: This publication contains general information only and Global Shares is not, through this article, issuing any advice, be it legal, financial, tax-related, business-related, professional or other. The Global Shares Academy is not a substitute for professional advice and should not be used as such. Global Shares does not assume any liability for reliance on the information provided herein.

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