Rethinking Four-Year Vesting

Vesting in startup companies is fundamental. It is the mechanism by which most founders and employees come to own their equity. This equity ownership plays a key role in driving innovation.

Despite major changes in how private companies are capitalized and generate liquidity, little has changed in the traditional vesting schedule. According to data from Pave, close to 90% of private companies still use this four-year vesting schedule for their equity grants.

This uniformity is inconsistent with something that founders and practitioners know well: equity doesn’t work best in a one-size-fits-all way. Equity is a tool to recruit, motivate, align and retain talented individual. Its best implementations are as varied as the companies and the talented individuals they recruit, motivate, align and retain.

Here we survey the historical four-year vesting convention and some of the alternatives companies are using to do these things better.

Why the Four-Year Vesting Schedule Exists

Why is four years the default vesting schedule to begin with?

Multiple possible explanations exist:

• During the time when our current conventions around vesting were established in the 1980’s and 90’s, four years was a relatively common timeframe for companies to go from being founded to a liquidity event in an IPO or acquisition.
• Four years represents a common “project/mission” length for many equity-linked goals.
• Four years is short enough to be tangible, but long enough to focus efforts on building long-term value.

Whatever the reason, four-year vesting schedules have become the dominant norm for private companies over the past twenty-plus years.

One way to understand the role of the four-year vesting schedule is to start by comparing several basic alternatives.

Suppose a company wants to grant 1,200 shares to an employee.

The company could:

• Issue all 1,200 shares at the outset subject to vesting over four years, with share vesting each month if the employee is still providing service.
• Issue the 1,200 in 48 separate issuances of monthly tranches of 25 shares each, so long as the employee is still providing service.
• Issue all 1,200 shares outright without any vesting conditions.

Issuing equity up-front vs in issuing in sequential grants

Distinguishing between the first two cases is non-obvious: they are interchangeable in terms of economic ownership:

• If you receive a grant for 1,200 shares that “vests” over four years, that really means you don’t own those shares until the vesting condition is met as those four years pass and you continue to provide service.
• In economic substance, that is functionally the same as receiving 48 sequential grants based on continuous service. In both cases you come to own the equity in monthly tranches over four years (ignoring any cliff).

Despite the similarities, several factors have traditionally favored “pre-issuing” a large block of equity subject to vesting instead of issuing the equity over time in tranches:

1. Recipient perceptions

While economically the two may be interchangeable, humans are not perfectly rational. Perception matters, and companies understand this.

Having a large up-front equity grant can give the recipient a sense of “owning” the full 1,200 shares – even if in reality ownership of those shares is fully dependent on the contingent future vesting conditions.

The perception of “owning” the equity from the up-front grant—even while subject to vesting—can also serve as a retention mechanism. This is sometimes referred to as “golden handcuffs”—an employee with a highly appreciated equity award that is still vesting stays with a company they would otherwise leave in order to continue vesting.

2. Administrative Cost

Historically, the cost of administering equity issuances tipped the balance in favor of minimizing equity transactions. Making a single grant of 1,200 shares was significantly less expensive than making 48 monthly grants of 25 shares.

Modern technology has shifted the balance of these factors, but both historical convention and marginal administrative costs continue to favor the single up-front issuance.

3. Tax

In some cases, the US tax code favors making large equity grants subject to vesting rather than a sequence of smaller grants for the same total quantity.

For companies that can take the position that their share value is very small, Section 83(b) elections allow a small upfront tax to be paid on the full grant and avoid ordinary income as the equity vests. This can result in large tax savings:

• A four-year grant of 1,200 shares of restricted stock with an 83(b) election filed at grant when the FMV is $1 will pay tax on $1,200 (~$400, depending on tax brackets).
• If the FMV of the shares increased and averaged $100 over the course of the vesting period, the tax liability would be based on $120,000 ($40,000)—and would be payable even without the benefit of being able to sell the stock.

This is such a benefit at the earliest stages that many investors view it as a mandatory due diligence check for founder and early employee stock.

The ability to recognize all the income upon grant using a Section 83(b) election is less appealing when that recognition requires paying thousands of dollars of tax up front.

Because of this, the benefit of making an 83(b) election mostly applies to founders and very early-stage employees.

4. Stock Options

Having a single grant date can benefit stock options because the exercise price of the option generally must be at least equal to the FMV on the date of grant (or else face punitive tax consequences for US recipients).

If the company’s valuation increases over the four-year period, granting an option on all the shares at the start of this period will result in a lower exercise price. If smaller grants are issued throughout the period, the exercise prices of the subsequent grants will have to increase along with the company’s valuation.

In the case of incentive stock options, the grant date also starts the two-year statutory holding period the employees must meet to receive preferential tax treatment on their sale of the underlying shares (employees also must hold the shares for one year after their exercise date—see our Guide to Incentive Stock Options).

Where the stock isn’t expected to be liquid for six years or more, this won’t affect employees (since they won’t be able to sell any of the stock until it is liquid). But where a liquidity event (e.g., IPO, acquisition, tender offer) is expected within a shorter time frame, this holding period factor for ISOs can favor of larger up-front grants.

Finally, Issuing the ISO in 48 separate grants means 48 grant dates and 48 different two-year holding periods. Modern equity management tools can handle this administration automatically, but older systems cannot.

Issuing equity up front vs issuing equity without vesting at all

A theoretical alternative to the four-year vesting schedule is to issue the full equity grant without vesting at all.

The problem with this is straightforward: If the employee quits the day after they are issued the shares, they still get the 1,200 shares. In theory and in practice, this is functionally a non-option for the traditional equity compensation goals.

Current Alternatives to the Four-Year Vesting Schedule

Annual Grants

An alternative to the four-year vesting is a version of the sequential grants introduced above: breaking the single equity grant into multiple annual grants. A number of successful tech companies like Stripe have begun using this type of structure.

Some Benefits of Annual Grants

No “sunk cost” equity

By making annual grants, it is easier for a company to manage cases where an employee’s equity grant would otherwise become incongruent with their role or the value they’re providing. This arises in contexts where a company’s equity has rapidly appreciated and solid contributors end up with out-of-market compensation packages once their vesting equity is accounted for. With a four-year grant they are locked into vesting outsized packages; with annual grants, the company can adjust future equity grants to account for the value of the equity.

Equity grant tied to performance

Using an annual grant can make it easier for a company to tie the value of an equity grant to performance rather than the timing of when someone joined the company.

Clearer picture of equity

To get a realistic picture of their equity, most companies with four-year vesting schedules need to project what equity will actually vest and what will be forfeited. Annual grants simplify this by removing the contingency of unvested equity.

Minimize the impact of underwater options

Companies generally expect their value to increase in value, but there is no guarantee this will happen. When company value decreases, options that are “underwater” can create significant morale and administrative costs. Annual grants minimize the impact of this by regularly re-setting the exercise price each year.

Some Costs of Annual Grants        

Recipient perceptions

As noted above, a common objection to annual grants is that employees will not be as motivated because the grant doesn’t appear as large.

This perception depends on how a company frames the awards to the recipient.

If done thoughtfully the difference can be minimal:

“Your on-target equity awards will mean that at the end of four years you’ll own 1,200 shares” differs little from “You will receive 1,200 shares subject to vesting over four years”.

Another perception factor is the role multi-year vesting plays in retaining employees who would otherwise leave.

When a company is growing quickly, many high-performers stay at a company because they are vesting equity with value that is greater than what they could earn elsewhere. This would often not be the case if they were receiving annual grants where the grant size was indexed to the company’s current fair value. 

That said, using the incumbency of vesting equity to drive retention itself comes with costs:

1. If an employee is staying because they are receiving outsized compensation, the company is paying outsized compensation. This is simply the other side of the equation.
2. This fact pattern encourages employees who want to leave to stay at the company purely for economic reasons. There is often a large cost to retaining employees through purely economic means when they would otherwise don’t want to be there.

Loss of tax efficiency from annual grants

For recipients who would choose to file a Section 83(b) election, there is a real tax advantage to issuing the entire equity grant up-front and filing an 83(b) election. A good test for whether an annual grant makes sense is whether the recipient would be likely to file an 83(b) election if the grant was issued as a four-year grant subject to vesting rather than in annual installments.

83(b) elections also become increasingly rare as companies emerge from the early stages and begin issuing options with equity that has real value. Because of this, the tax advantages of making four-year grants vs annual grants are not relevant to the lion’s share of private-company equity awards.

Reduced upside

Certain employees are attracted by marginal levels of outsized upside potential.  This outsized upside can be increased on the margin by the structure of the four-year grant.

The practical impact of this is limited though—in the true outlier company success case, much of the outsized growth will have been captured by a single year or two of equity grants that would also occur in the annual grant context.

Administrative burden of annual grants

Of all the factors, this is the one that has changed the most since the four-year vesting schedule became normalized decades ago. The cost of issuing equity has been reduced substantially as technologies have emerged to make the approval and execution of awards orders of magnitude more efficient. 

Alternative Vesting: Variable % Vesting

Amazon is one well know company that has popularized a vesting schedule in which equity vests over four years, but the quantity vesting in each year is not equally weighted.

For example a vesting schedule might look like:

• Year 1 - 5%
• Year 2 - 15%
• Year 3 - 40%
• Year 4 - 40%

Other tech companies have similarly adjusted vesting over four-year (and other) terms, with different annual weights—some frontloaded, some backloaded.

The pros and cons of this approach depend on the schedule. At the simplest level, a backloaded schedule tends to optimize for retention, a frontloaded schedule tends to optimize for hiring. Depending on the allocation, the schedule can share more or less in common with a straight-line four-year vesting grant.

Alternative Vesting: Term tied to scope of work

Another approach is to design vesting schedules that are meant to track the recipient’s “job to be done”—the time period where the recipient’s target mission is expected to be completed.

This rationale is used by a number of companies who use six-year vesting periods to map longer-term goals.

The underlying idea is that the equity grant’s vesting is best tied to the expected length of the recipient’s current mission: if that mission is expected to take two years, a two-year schedule makes sense. If it’s expected to take six years, a six-year schedule makes sense.

A variant of this approach is milestone-based vesting, where vesting is tied to the achievement of specific goals.

Milestone-based vesting is a nice tool but is worth using with caution. Part of equity’s value as a form of compensation comes from its ability to broadly align incentives towards top-level enterprise value in cases where the specific ways to do that are not yet knowable. If the target outcomes can all be defined with enough specificity to create a milestone to trigger vesting, there may be other forms of incentive compensation that work more efficiently than equity.

Conclusion

A number of viable alternatives exist to the traditional four-year vesting period. Companies that are looking to maximize the value of their equity are wise to explore structures that leverage current technologies and work best for their goals.