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By Karen E. Klein
JANUARY 20, 2000

Carrot and Stick: The Psychology of Options Vesting Schedules

Setting up the right system requires you to balance several conflicting issues


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See other recent Smart Answers columns on options:

The Options Option: How Private Companies Can Use Stock as an Incentive

The ESOP: Motivator for Staff, Tax Breaks for the Boss

Smart Answers Archive

Q: Is it better to structure an stock-option plan that vests monthly or yearly? What are the pros and cons of each?
—S.G., San Francisco

A: Stock options have become an important part of employee compensation, especially in the fast-moving world of Internet startups. Yet they're complex financial instruments that pose myriad administrative and strategic questions such as yours.

First, some brief definitions for the uninitiated. Giving management team members and other employees stock options means you grant them the right to buy a certain number of your company's shares at a specific price (the "strike" price) within a specific period. (For more on options of closely held companies, see "The Options Option: How Private Companies Can Use Stock as an Incentive," Nov. 25, 1999 and "The ESOP: Motivator for Staff, Tax Breaks for the Boss," Nov. 30, 1999.)

You can grant options as soon as you hire someone. But since they're incentives for employees to stick around, management typically structures the plan so they become negotiable over time. That process is called vesting, and it lets employees earn the right to exercise their options (buy stock with them) or sell them only after they've been at the company for some set period of time.

"GOAL-DRIVEN." The vesting schedule is an important strategic tool for startups that need highly motivated and skilled staff, but can't afford to pay high initial salaries. Venture-capital firms often feel more secure that key team players won't leave if they're working toward the next vesting period.

"When you have a small team, a large portion of your success is going to be very goal-driven," explains Chip Austin, co-founder and managing principal of i-Hatch Ventures, a New York venture-capital firm specializing in early-stage Internet companies. "You have your launch and various rounds of raising capital. Each time you go back for more funding, there is a set of goals that has to be met in order for the VC firms to invest more money. A team that's very focused on getting to the next level and seeing their options increase in value will work harder to meet those goals within a particular time frame."

On the West Coast, where employees have become very savvy about the worth of options, about 80% of Internet-service-related startups create options plans that vest over four years, with a one-year "cliff," says Austin. "This means that for the first year, you don't vest at all. At the end of your first year, you vest 25%, and then it's monthly vesting for the next three years — so every month you vest another 1/36th of your options." Complicated enough? Hold on, it gets worse. After startups have been around a year, they often get new infusions of capital. At that point, they may distribute more options that bear a higher strike price and vest on a different schedule.

WHEN THEY'RE WEAK. The timing involves some tricky psychological calculations. If you structure the schedule (after the first-year cliff) so that only a small amount of options vests each month, key people may take their 25% — particularly if it's worth a lot of cash — and move on after year one. "A lot of recruiters track vesting events, and they start calling executives of Internet companies about 60 days before the event, when they're starting to step back, and they become vulnerable to new offers," Austin says.

If a larger amount of options vests at once but over a somewhat longer period, employees may be more willing to hang on for the next big payoff. On the East Coast — and outside the frenetic pace of Internet startups — vesting is usually quarterly. That's a compromise between investors' and employees' interests, says Graham Anderson, of New York City-based Euclid Partners. Employees who come from more traditional companies that may grant smaller amounts of shares that vest over a longer period — say 10 years — typically expect their options to vest quarterly or semi-annually.

You must decide what you want to achieve with your options vesting schedule, experts say. A top management person who really believes in your startup may take half his or her normal salary along with options that vest immediately. In that case, the risk the person may leave at any time is counterbalanced by the advantage of getting such a skilled person. For a lower-level employee, a market-rate salary may be a more important hiring tool, with options that vest over a longer period serving as an incentive to stay. Clearly, there's no single answer, so thinking through what your goals are is key to setting up an options plan that works for you.

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