April 29, 2011 2 Comments
Consider this an “opinion piece”, but one shared between several founders and investors which in reality should not be a contentious issue anyways. In other words, we’re not going out on a limb here folks.
Simply put, you should seek board approval to change the vesting schedule of option grants to existing employees so that the standard one-year cliff vesting period is eliminated. We’ll provide some of the thinking around this below which you should feel free to use in discussing the topic with your board.
First, lets spend two paragraphs on the ubiquitous one-year cliff. Cliff vesting on option grants was initially added to option terms to provide a sort of “trial period” for a Company and employee. The trial period with equity is important because without it employees who are let go or quit soon after joining would all have a right to own equity (if they choose to exercise their options). This adds a potentially large number of small common shareholders who in some cases may not have a favorable view of the Company or the executives who fired them. This makes for a headache when seeking approvals from shareholders, both by adding a large number of small shareholders to the cap table, and by adding shareholders who may default to vote against the Company recommendations on key voting issues (getting fired can make one bitter…).
The one-year cliff is likely here to stay for new employees, and it should. If a potential hire says they want their one-year cliff eliminated they are showing they do not have a long-term commitment to the Company and/or do not trust that the Company has a long-term commitment to them. It should never be a point of negotiation, and a company should NEVER consider the upcoming end of a cliff vesting period as a factor in making a decision to dismiss an employee - this ‘Lucy pulling the football away from Charlie Brown’ approach may seem like a decent idea in the short term, but it is a jerk move that signals you care more about equity than employees (good and loyal employees help make equity valuable).
So, given all of this, why eliminate the cliff period for refresh grants to existing employees? The primary reason is that if you have decided to give them more equity they are presumably doing at least an adequate job for your company and you intend to keep them around for a while. In other words, the “trial period” has ended and they have passed. Why subject them to another “trial period” with the new grant?
There are good reasons to make this change, and reasons to potentially not do it or not set it as a hard and fast rule. We’ll list them below and let you decide (PLEASE comment on this article with your opinion on the best approach).
Reasons to eliminate cliff:
- Goodwill. Your goal with the refresh option grant may be to recognize an employee’s strong performance, great work on a crucial project or recent promotion, all positive things of course. When you tell the employee about their new option grant, telling them it is not subject to cliff vesting but will instead start to vest right away sends a further positive message about their importance to the business and your faith in their future success as an employee, and sends a very clear signal that their “trial period” has ended. It may seem like a minor thing, but we have seen this message have great impact a number of times (think of it as a really good icing on the cake).
- Administration of Options. This is a minor reason – tracking option grants without a cliff vesting structure is easier to deal with for both the company and employee, especially if the employee has multiple grants and only one is subject to a cliff. Again, a minor reason, but we wanted to find at least two good ones…
- At-Risk Employees. There will be situations where you grant additional options to an employee as part of a package to keep them from leaving for a different job, or in cases where you are concerned they will leave for a new role and want to provide additional incentives for them to stay. In these cases you might want to use a cliff on the new option grant as you would not want them to walk out the door with extra vested options if they decide to leave in spite of your efforts to keep them on board. You can maintain a cliff structure on a case-by-case basis as explained below, so instead of using a cliff for all refresh grants, we’d recommend only applying it in specific situations where it may be warranted.
- Planned Dismissals. If you are considering cutting one or more people from the Company in the next few months but are in the process of doing a broad option refresh, you may be in a situation where not providing the option refresh to the employee(s) you might let go could signal an issue to them that you do not yet want to signal. In this case you may decide to give them additional options along with the rest of the team as part of the refresh even though you know they may soon be gone. While you could apply a cliff vesting period to these grants as in #1 above, our recommendation is to not do this but instead provide the same refresh structure across the board. Two reasons for this – (1) You may not end up letting them go after all and (2) Unless it is a VP level person, the amount of new options vested in the time period between the refresh and their dismissal will likely be small, and there is a decent amount of goodwill in not trying to “nickel and dime” a departing employee over their option grants, especially as by default this person will have been at the company for at least a year (if not, their initial 12 month cliff would still be in place).
What about when an employee who is not at risk decides to leave within twelve months of this new grant? Without a cliff in place, an employee departure within twelve months of a new grant may cause some dilution as they will have the right to exercise options that would otherwise be lost to the cliff. While the dilution here is real, it should be fairly minor as most refresh grants are well under one percent of the overall equity and at most the equity lost would be eleven months of a 48 month vest, or about 23% of the total refresh grant. The main purpose of the original cliff is to avoid adding a short-timer to the cap table, but since an employee receiving a refresh grant already has vested options, setting a cliff on the refresh grant will not have any impact on whether or not they end up on your cap table.
Note on Option Refresh grants made prior to the one-year employment anniversary: For additional options granted to an employee who has not yet completed their first year of employment, so is still within their initial one-year cliff vesting period, you should include a cliff vesting period for the new options that expires on the same day that the original cliff period ends. In other words, apply a cliff vesting period on the new grant that runs until the one-year employment anniversary. This will prevent a situation where the employee is under the cliff for their original grant but starting to vest on a subsequent one and keeps the one-year cliff universally intact. Usually this period would only be a few months as it is rare to see additional options issued to an employee within the first six to nine months of their employment.
Implementing the change. You should not have to structurally change anything in your stock option plan to accommodate the elimination of the vesting cliff for refresh grants. Discuss this topic with the board and if there is approval, you can agree that unless otherwise noted, all future option grants to existing employees will not be subject to a cliff vesting period unless the employee is still in their first twelve months of employment, in which case the new grant will have a cliff period that ends on the same day as their existing option grant. Going forward you can default to this approach and simply notify the board if you have a refresh grant where you want to apply a cliff period and treat this as an exception to the rule.
We welcome comments on this topic and are interested to learn if you agree or disagree with the recommended approach. Please give us additional reasons (Pro and Con) as well – we appreciate the input.