Silicon Valley: S01E01 (Part 2): Programmers at a tech startup brag about being remunerated with top pay and “vested stock options”. Top pay, we know and want. But what are vested stock options?
Vested stock options generally find relevance in Employee Stock Ownership Plans (ESOPs) whereby companies (usually startups) offer their key employees equity as part of their compensation package. This stock does not accrue to the employee right away but has to vest first. Vesting is the process of earning the stock, whereby the employee receives ownership of the stock over a fixed period of time or, in some cases, after the company hits a milestone.
An instance of the latter is the hyped compensation package of Elon Musk whereby the vesting of each tranche of equity is contingent on the company achieving a pre-determined goal.
In India, ESOPs can only be granted to full-time employees, and not to part-time employees, advisors, or consultants, who can be granted non-statutory stock options. In addition, ESOPs cannot vest in the employee within one year of their granting, as there is a mandatory one-year cliff.
Think of a cliff as a standstill period or a moratorium during which no vesting can take place. After the cliff, the stock options gradually vest over an agreed-upon period of time.
For more information, refer to our blog post titled “Did you know that there is a mandatory 1-year cliff on ESOPs?”
The aforementioned “agreed upon a time” after the mandatory one-year cliff over which the stock vests are laid down in a vesting schedule. A 1+3 vesting schedule is among the most common in India, whereby the vesting of stock takes place over a period of 3 years after the mandatory 1-year cliff.
Creating a vesting schedule is where co-founders or promoters can get creative. Apart from the mandatory one-year cliff, the law prescribes no limitations on a vesting schedule.
For example, for an invaluable employee whom the company wants to retain for a longer period of time, the promoters would structure a 1+4 schedule whereby the stock vests over the four years following the mandatory one-year cliff. The employee could be further incentivized by structuring a vesting schedule graded at 10%, 20%, 30%, and 40%, each chunk of equity accruing to them at the end of each year, with the largest chunk reserved for last. The latter would incentivize the employee to stick around until the end of the fourth year as a large portion of equity i.e. 40% still remains unvested even at the end of the third year.
There are pros and cons to any vesting schedule, and a promoter needs to create a balanced vesting schedule taking into consideration both the organization’s priorities and the employee’s acquiescence to such schedule.