What are vesting schedules?
Vesting schedules define the timeline over which restricted share awards from employee long term incentive plans become available for employees to own and sell.
What does cliff vesting mean?
Cliff vesting is when the entire award (100%) vests on one single date, ie. it falls off a cliff.
What does graded vesting mean?
Graded vesting is when an award will vest in tranches over a longer period of time, an example might be 25% of the award vesting each year for 4 years.
Why would companies choose cliff vesting vs graded vesting or vice versa and what is better for employees?
Different industries and countries have different vesting schedules that are normal market practice but even within a single company and country there can be multiple vesting schedules based on level, job of individual circumstances. Graded vesting is good for employees as they typically will be getting some of the award vesting sooner and have vesting occasions more often. From a company point of view cliff vesting is simpler to administer and accrue for and could be seen as stronger retention as the entire award is forfeited if an employee resigns even just before the cliff vesting date.
When an employee gets awarded a long term incentive or LTI by their company in addition to the value of the award one of the most important features to understand is the vesting schedule. Whether it is restricted stock units, performance share plans, employee stock options or deferred cash it will almost certainly have a vesting schedule. This is essentially what makes it a ‘long’ term award as the employee has to wait and remain employed for a period of time before the award actually becomes theirs. As mentioned vesting schedules vary enormously by industry, country and by company so make sure you ask if you are changing jobs to ensure you understand if your future LTIs will have a much more unfavorable vesting schedule.
Cliff vesting is more traditional and still very common, it is easy to understand for employees and management who are looking to retain employees. If an employee resigns before the vesting date then they will usually forfeit the entire award, if they are lucky they may go to a new company who will compensate them for this ‘lost’ award.
Tech companies these days typically have employee share plans with shorter vesting periods utilizing a graded vesting schedule. These can become harder to keep track of if there are multiple awards with multiple vesting tranches all overlapping over a period of years but they can also be very effective retention and attraction tools. One outcome from more regular graded vesting plans is that they can become seen as a reliable part of the employees pay and some employees can become reliant on this regular vesting for their lifestyle and regular costs they incur. This can obviously become a problem if the situation changes – eg the share price drops, the employee doesn’t continue to get the award etc. Longer, cliff vesting awards are less likely to be relied upon by employees and are more of a big pay day occurring only once a year (if it is an annual plan).
As an employee, a recruiter or a compensation and benefits professional make sure you are thinking not only about the value of any award but also about the vesting schedule and how that impacts the situation at hand.
Follow the blog for a future topic where we will cover the different vesting schedules by country/industry and what is typical vs unusual. Also, be sure to use our instant free report if you ever do need to perform a valuation on any unvested stock award whether it is cliff vesting or has a graded vesting schedule.