Key Takeaways
- Definition: Cliff vesting is a mandatory waiting period, most often one year, before any employee equity (like stock options) begins to vest.
- The Industry Standard: The most common equity schedule used by startups is 4 years of total vesting with a 1-year cliff.
- The High Risk: If an employee leaves even one day before the cliff is reached, they forfeit 100% of the granted equity, meaning they walk away with nothing.
- Why Founders Use It: The cliff acts as a crucial retention tool, protecting the company’s equity pool from short-term hires and reassuring early backers like Angel Investors.
- Founder’s Focus: Founders need to be transparent about the cliff period in contracts and should be prepared to address negotiation or alternatives to retain top talent for their growing side hustle.
Ever offered a new team member stock options and had to explain that they don’t get full ownership right away? Or maybe you’re a founder yourself, trying to figure out the best way to give your early employees a stake in the company’s future?
The journey from a promising side hustle to a scalable startup often requires founders to understand complex equity terms. This whole idea of “earning” equity over time can seem a bit complex at first. One common piece of this puzzle is cliff vesting.
In this blog post, we’ll break down exactly what cliff vesting means for startup equity. We’ll explain why startups use this waiting period, how it works with clear examples, and what you, as a founder, should consider when implementing it.
We’ll also touch on whether there are other ways to handle equity vesting. By the end, you’ll have a solid understanding of cliff vesting and how it fits into your overall equity strategy.
First, let’s understand what vesting is.
What is Vesting?
When employees are offered a piece of ownership in the company, often in the form of stock options or shares, it doesn’t usually mean they get it all at once on day one. Instead, there’s a process called vesting. Think of vesting like earning your ownership over time, rather than getting it immediately.
The main reason startups use vesting is to encourage employees to stay with the company for a longer period. By making the ownership contingent on continued employment, the company hopes to keep talented individuals around and aligned with the company’s long-term success.
If an employee leaves the company before a certain amount of time has passed, they typically only get to keep the portion of ownership that has “vested” or been earned up to their departure date. The rest goes back to the company.
This earning of ownership usually happens over a set period, which is often four years. So, if an employee is granted stock options that vest over four years, it means they will gradually gain full ownership of those options over that four-year period, as long as they continue to work at the company.
It’s a way to reward long-term commitment and ensure that employees have a real stake in the company’s future success.
Here is a YouTube video by BetterLegal that demonstrates what vesting is.
While vesting defines how ownership builds over time, cliff vesting adds an extra condition, a waiting period before anything begins. Let’s break down what that means.
What is Cliff Vesting?
Cliff vesting is a specific type of vesting schedule for equity in startups. It involves a significant initial waiting period before any of the granted equity begins to be earned (vest).
What are the Key Aspects of Cliff Vesting?
The “Cliff” as a Waiting Period
The term “cliff” refers to a set amount of time at the beginning of an employee’s tenure during which no equity vests. This means you have to work for a certain initial period before you start to own any part of the company.
It’s a period where the employee must remain with the company to begin earning their stock options or shares. Think of it as a hurdle you need to clear to start getting your ownership.
Common Example: One-Year Cliff in a Four-Year Schedule
A frequent vesting structure includes a four-year total vesting period with a one-year cliff. This is the most common vesting schedule used by startups, often cited as a standard set by early Silicon Valley venture capital firms.
In this scenario, an employee must complete a full year (12 months) of employment before any of their equity starts to vest. So, for that first year, you don’t officially own any of the promised stock options or shares.
The idea of a “cliff” might sound abstract, but it becomes clearer when you see how it plays out in real-world situations. Here’s how cliff vesting actually works.
How Does Cliff Vesting Work? (With Examples)
To really understand how cliff vesting works, let’s walk through a typical example step by step. Imagine you join a startup and receive a grant of 1000 stock options. Your employment agreement states that these options will vest over four years with a one-year cliff.
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Start Date
You begin working at the company on Day 1. From this day until you complete one full year of employment, the “cliff” period is in effect.
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Before the One-Year Mark
During these first 12 months, even though you are working hard and contributing to the company, none of your 1000 stock options will have vested. You don’t officially own any of them yet.
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Reaching the One-Year Cliff
Once you complete exactly one year (12 months) of continuous employment from your start date, you will pass the cliff. At this point, a significant portion of your stock options will typically vest all at once. In a common four-year vesting schedule, the portion that vests at the one-year cliff is often 25% of the total grant. So, in our example, after one year, 250 of your 1000 stock options would become yours.
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Vesting After the Cliff
After you’ve passed the one-year cliff, the remaining 75% of your stock options (in this case, 750 options) will continue to vest gradually over the remaining three years of the vesting schedule. This usually happens in equal installments, either monthly or quarterly.
- Monthly Vesting: If the remaining options vest monthly over three years (36 months), then each month you would earn an additional 20.83 options (750 options / 36 months).
- Quarterly Vesting: If they vest quarterly over three years (12 quarters), then each quarter you would earn an additional 62.5 options (750 options / 12 quarters).
Example Scenarios
- Example Scenario 1: Employee leaves after 10 months – result: no equity vested. If you were to leave the company after only 10 months of working there, because you haven’t passed the one-year cliff, none of your 1000 stock options would have vested. You would leave without owning any part of that equity grant.
- Example Scenario 2: Employee leaves after 1 year and 1 month – result: a portion of equity vests (usually 25% in a 4-year schedule with a 1-year cliff). If you stay with the company for one year and one month, you have passed the one-year cliff. At the one-year mark, 250 of your options would have vested. In the one month after the cliff, an additional portion would have vested according to the ongoing schedule (either monthly or a fraction of the quarterly amount). So, you would leave owning at least 250 options, plus a small additional amount for that extra month.
Understanding this step-by-step process and these examples helps clarify how cliff vesting works and what the implications are for employees regarding their startup equity.
Check out this very important and relevant Reddit thread titled “Cofounder dismissed before cliff wants 7.5%, what should I do?” It details the exact nightmare scenario the cliff is designed to prevent: a non-contributing co-founder trying to walk away with significant “dead equity.”
So now that you know how cliff vesting operates, the next question is why do so many startups prefer it? Let’s look at the business logic behind this setup.
Why Do Startups Use Cliff Vesting?
Startups often choose to implement cliff vesting for a few key reasons that benefit the company in its early stages:
1. Incentive for Retention
The one-year cliff acts as a strong reason for employees to stay with the company for at least that initial period. Knowing that they won’t earn any of their valuable stock options or shares if they leave before the cliff ends encourages them to remain committed.
This is especially important in the fast-paced and often uncertain environment of a startup, where employee turnover can be disruptive. The cliff creates a sense of anticipation and a reason to stick around and see the company through its early growth phases.
Employees understand that their loyalty during this critical first year will be rewarded with a significant portion of ownership.
2. Discouraging Short-Term Hires
Cliff vesting can help startups filter out individuals who might not be serious about a long-term commitment to the company. Someone looking for a quick job or who is unsure about staying with a startup through its initial challenges might be less inclined to join if they know they won’t see any equity for a full year.
This helps the company focus on hiring individuals who are genuinely invested in its mission and are willing to contribute for the long haul. It reduces the risk of investing time and resources in employees who might leave relatively quickly, without having earned any stake in the company’s future.
It also reassures early backers, such as Angel Investors, who perform due diligence and prefer to see commitment from the entire team.
3. Administrative Simplicity
In the very early days of a startup, resources are often limited, and administrative processes need to be as simple as possible. Managing equity for a large number of employees who might join and leave within a short period can become complex.
A cliff vesting schedule simplifies this process in the initial stages. The company only needs to start tracking the vesting of equity for employees who remain past the cliff. This reduces the administrative burden of issuing and managing small amounts of vested equity for employees who depart early on.
It allows the startup to focus its limited administrative capacity on more critical tasks during its formative months.
4. Alignment of Interests
Cliff vesting helps to align the interests of the employees with the long-term success of the company. Since employees need to stay for at least the cliff period to begin earning their equity, they are incentivized to contribute to the company’s growth and work towards its future success.
Their personal financial gain through their stock options becomes tied to the company achieving its milestones over a longer timeframe. This shared interest can create a stronger sense of teamwork and commitment, as everyone is working towards the same ultimate goals.
Employees understand that their patience and hard work will eventually translate into ownership in a potentially successful venture.
This Reddit thread titled “We should push back against the 1 year cliff as a standard” captures the employee perspective, arguing that the 1-year cliff unfairly places all the risk of a bad cultural fit on the employee, especially if the company decides to fire them right before the vest date. This shows the moral challenge founders face when setting the schedule.
While cliff vesting offers advantages for startups, it also has important implications for employees. Here’s what you should keep in mind if your offer includes a cliff vesting clause.
What Should Employees Look For Regarding Cliff Vesting?
When you join a startup and receive stock options or shares as part of your compensation, it’s really important to understand the details of the vesting schedule, especially if it includes a cliff. Here are some key things you should pay close attention to:
1. Understand the Cliff Period
The first thing you need to know is exactly how long the initial waiting period, or “cliff,” is. This is the time you need to stay with the company before any of your equity starts to become yours.
Make sure your offer letter or equity grant documents clearly state the length of this period – it’s often one year, but it could be different. Don’t assume it’s a standard one year. Always confirm the specific duration for your grant.
Knowing this timeframe is crucial for planning your career and understanding when you will start to see the benefits of your equity.
2. Understand the Vesting Schedule After the Cliff
Once you know how long the cliff is, you also need to understand how the rest of your equity will vest after that initial period ends. Will it vest monthly, quarterly, or annually? And over how many years in total?
For example, if there’s a one-year cliff and a four-year total vesting period, the remaining 75% of your equity will vest over the next three years. Knowing the frequency and duration of this post-cliff vesting will help you understand the timeline for fully earning your ownership in the company.
This information is important for your long-term financial planning and your understanding of your stake in the company’s future.
3. Negotiating the Cliff (if possible)
In some situations, particularly if you are a senior-level hire with significant experience or highly sought-after skills, there might be room to negotiate the terms of your equity grant, including the cliff. While a one-year cliff is common, it’s not always set in stone.
You might be able to negotiate for a shorter cliff period or even a partial vesting of equity before the full cliff ends. It’s worth having a conversation about this during the offer stage. Especially if you are leaving vested equity at a previous employer. However, be aware that early-stage startups may have less flexibility on these terms.
4. Impact of Leaving Before the Cliff
It’s absolutely essential to fully understand the consequences of leaving the company before the cliff period is over. As we discussed earlier, if you depart before the cliff ends, you will typically forfeit all of your unvested equity.
This means you will leave without owning any of the stock options or shares that were granted to you, even if you were close to the end of the cliff. Make sure you are clear on this policy and consider it carefully when making decisions about your employment at the startup.
Understanding this “all or nothing” aspect of the cliff is vital for managing your expectations and making informed career choices.
This YouTube video explains the best practices of vesting and cliff for employees and founders.
If cliff vesting feels too rigid, don’t worry. It’s not the only approach out there. Companies and employees sometimes explore other vesting structures that offer more flexibility. Let’s take a look at those alternatives.
Are There Alternatives to Cliff Vesting?
While cliff vesting is a common way for startups to structure their equity grants, it’s important for founders to know that it’s not the only option available. There are other approaches to vesting that might better suit certain company cultures or hiring strategies.
Vesting Without a Significant Cliff
Some companies choose to use vesting schedules that don’t have a long initial waiting period before employees start earning their equity. In these cases, equity might begin to vest much sooner, for example, on a monthly basis right from the employee’s start date.
This means that even if an employee leaves relatively early, they will still have earned a portion of their stock options or shares based on the time they worked at the company.
This approach can be seen as more employee-friendly from the start, as it provides a more immediate sense of ownership and reward for their contributions, even in the short term.
Cliff Vesting is Common, Not Universal
It’s crucial for founders to understand that the one-year cliff is a rule that every company may not follow. The decision of whether or not to implement a cliff is ultimately up to the individual startup.
Factors like the company’s stage, its hiring needs, and its overall compensation philosophy can influence this decision. Some startups might opt for a shorter cliff, like six months, or even no cliff at all. They might choose for the equity to vest gradually from the beginning of employment.
Founders should carefully consider the pros and cons of cliff vesting versus other vesting schedules. It must be based on their specific circumstances and goals.
Conclusion
To wrap things up, cliff vesting is a specific way startups often structure the process of employees earning their ownership in the company. It involves an initial waiting period where no equity vests, followed by a more regular vesting schedule.
Startups use this method to encourage employees to stay for the long term and discourage short-term hires. It also simplify early administration and aligns everyone’s interests with the company’s success.
For startup founders, understanding the ins and outs of cliff vesting is important for designing fair and effective equity plans. While it’s a common practice, it’s not the only way to handle vesting. Considering alternatives might be beneficial depending on the company’s specific needs and culture.
Ultimately, the goal is to use equity in a way that attracts, motivates, and retains the talented individuals who are crucial to building a successful company.
Want to learn more about startup equity, stock options, and other important terms for building your company? Head over to Startup Words! You’ll find clear explanations of vesting schedules, employee compensation, and everything else you need to know to make smart decisions about equity. Visit Startup Words today to boost your understanding of startup language.
Frequently Asked Questions (FAQs)
What happens to my VESTED shares when I leave the company?
Once shares are vested, they belong to you, but you must usually purchase them from the company first. This is called exercising the options. Companies typically give you a Post-Termination Exercise Period (PTEP), often only 90 days, to buy those shares at the pre-determined strike price. If you miss this deadline, even your vested shares can expire.
Is there a tax cost when my shares vest or when I buy them?
Yes, there is often a tax impact, especially when you exercise (purchase) your vested shares. This can create a cash problem because you might owe taxes. This will be based on the difference between the low purchase price and the current value. This is true even though you can’t sell the private company shares yet. It’s vital to consult a tax advisor to understand the full financial liability before exercising.
What is “Double-Trigger Acceleration,” and why is it preferred by employees?
Acceleration is a clause that makes your unvested shares vest faster. Double-Trigger Acceleration is highly favored because it protects you in 2 cases. One, if the company is sold (Trigger 1). Two, if you are fired without cause by the new owner (Trigger 2). If only the company is sold (Trigger 1), vesting continues under the new owner, keeping you motivated to stay.
Does the vesting schedule distinguish between a “Good Leaver” and a “Bad Leaver”?
Yes. Contracts often define a “Bad Leaver” (e.g., termination for misconduct or fraud) vs. a “Good Leaver” (e.g., retirement, disability, termination without cause). A Bad Leaver usually forfeits all vested and unvested equity. A Good Leaver typically gets to keep all their vested shares.
What is the standard vesting schedule for the founder’s own stock?
Founder equity is almost always subject to the same vesting schedule as employees (the 4-year vesting, 1-year cliff). This is done primarily to assure Angel Investors and Venture Capitalists during due diligence that the founder is committed for the long term. It ensures they can’t walk away with a large share of the company if they quit early.