Finance guide: Cliff vesting
What cliff vesting is, advantages, disadvantages, and examples
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1 minute
August 13, 2024
For startups and high-growth companies, cliff vesting can be a particularly valuable method of retaining talent during critical early stages. It also provides a clear incentive so that employees feel that they have “skin in the game” and work hard for the company’s future success.
In this guide, we’ll discuss how cliff vesting works and its advantages and disadvantages. We’ll also review cliff vesting examples.
Key highlights about cliff vesting:
Isabel Peña Alfaro is a guest contributor. The views expressed are hers and do not necessarily reflect the views of Rho.
Before we dive into cliff vesting, let’s take a step back. What is vesting?
Vesting is the process by which an employee earns the right to receive benefits, such as stock option plans or retirement benefits and funds, from their employer.
Now, what is cliff vesting?
Cliff vesting is a type of vesting in which an employees options or equity plan becomes fully vested on a specific date. So, an employee would receive no vested benefits (such as shares in the company) until reaching the predetermined vesting date.
As an extra note, venture capitalists (VCs) provide funding to startups in exchange for equity. When VCs invest, they often require the company to implement vesting schedules for founders and employees, including cliff vesting.
Cliff vesting and graded vesting are two distinct approaches to employee vesting schedules.
As mentioned above, cliff vesting is when an employee becomes fully vested in their options or equity plan after a specific period. This creates a clear "cliff" where ownership rights are granted suddenly and completely. For example, an employee with a one-year cliff would receive no equity until their one-year work anniversary, at which point they would become 100% vested.
In contrast, graded vesting allows employees to gradually accrue ownership rights according to a predetermined schedule. For example, in a five-year graded vesting plan, an employee might receive 20% of their benefits each year until reaching full vesting after the fifth year.
Graded vesting can offer employees a sense of progress and may be more attractive to those who are unsure about long-term commitment while still providing some incentive for retention.
In this method, employees earn their stock options over a specified period. It can be structured in a variety of ways, but employees have to wait until a certain period has passed before any of their stock options vest.
Incentive/Reason: This approach incentivizes employees t stay with the company for at least the duration of the clifferiod, ensuring they are committed before receiving any vested benefits.
Milestone vesting ties the vesting of equity or benefits to the achievement of specific company or individual performance goals, rather than a period of time. These milestones could include completing a significant project, reaching a sales target, or contributing to the company's initial public offering (IPO).
Incentive/Reason: This method works to align the employee interests with the company’s strategic goals.
Hybrid vesting is a combination of both time-based and milestone vesting. It allows companies to both incentivize long-term commitment and align employees with specific performance outcomes.
Incentive/Reason: Hybrid vesting allows employers to create a more tailored and flexible vesting schedule that addresses their unique needs for employee retention and motivation, making it particularly effective for startups and growth-stage companies looking to balance employee incentives with business objectives.
Employees do not accrue any vested benefits during the cliff period, which typically ranges from 1 to 4 years. The shares can vest all at once or gradually after the cliff period.
If employees are vested gradually after the cliff period, once the cliff period ends, the reward is often 25% of the total equity grant.
They become fully vested if they remain with the company until the end of their entire vesting schedule.
In terms of cliff periods, Internal Revenue Service (IRS) regulations dictate that vesting periods can range from immediate to a maximum of 6 years.
Let’s look at some specific scenarios.
A 3-year schedule is one in which an employee becomes fully vested in their benefits after completing three years of service.
Consider an employee granted 1,000 stock options and a 3-year cliff vesting schedule. The employee would have 0% vesting for the first two years and 364 days of employment, but would receive access to all 1,000 stock options at once on their third anniversary with the company.
This is a common approach where an employee receives no vested benefits for the first full year of employment, but becomes partially vested after completing their initial year.
Consider an employee who is granted 1,000 stock options under a 2-year vesting schedule with a 1-year cliff. Their options would vest 0% during the first 12 months, but the employee would suddenly vest 25% of their options (250 shares) on their one-year work anniversary.
After the cliff, the remaining 750 shares would vest gradually over the next year, typically on a monthly basis.
This is a common schedule in which an employee receives no vested benefits during their first year.
Under this model, the employee with 1,000 stock options would have no vested options until their first work anniversary, at which point they would vest 25% (250 shares). The remaining options would vest gradually over the next three years, typically on a monthly basis, until the employee is fully vested at the end of the four-year period.
Cliff vesting offers several advantages for both employers and employees.
Cliff vesting is simple and predictable. Both parties can easily know exactly when the benefits will become available.
It allows employees to make retirement plan decisions more effectively. Cliff vesting is directly related to employer contributions in retirement plans, such as 401(k) plans, and other employer-sponsored savings plans.
It also saves employers money. Employers are not required to provide full benefits to employees who leave before the end of the vesting specified period.
Cliff vesting offers a substantial financial incentive for long-term commitment. Employees can become fully vested in their benefits all at once, which can give them a considerable reward. As a result, individuals may be motivated to stay with the company until they reach the vesting date to receive their full benefits.
With a cliff vesting plan, employers do not need to pay full benefits to employees who leave before the end of the vesting period. All unvested benefits are forfeited, which can result in significant cost savings for the company.
Moreover, improved employee retention can positively impact a company's valuation. Stable and committed employees are often valuable assets contributing to long-term growth and success.
Now, let’s talk about the other side of the coin.
Employees may feel trapped in their jobs if the company's value increases significantly during the cliff period. If this happens, there’s a possibility that employees who feel constrained by the schedule will have decreased morale and engagement.
Employees risk forfeiting all accrued benefits if they leave the company or are terminated before reaching the cliff date. This can be particularly challenging for employees who may need to leave the company for reasons beyond their control, such as personal circumstances or economic downturns.
If a company is taken over before the cliff period ends, employees may lose their unvested benefits if the acquiring company does not honor the existing vesting schedules.
This adds an element of uncertainty and risk for employees, potentially leading to decreased motivation and loyalty if they feel their hard work and commitment will not be rewarded due to external circumstances.
Cliff vesting can incentivize employees to leave the company immediately after the initial vesting period ends, a phenomenon known as the “cliff effect.” This can lead to a surge in turnover that disrupts company operations, hiring, and training costs.
This pattern can create a cycle where companies continually lose experienced employees just as they become fully trained and productive, impacting overall organizational stability and growth.
Let’s look at two examples of cliff vesting.
In the first one, an employee is granted 1,000 stock options with a 4-year vesting schedule and a 1-year cliff. The employee will receive 25% of their shares after their first year, and the remaining 75% will vest monthly over the next three years at a rate of approximately 20.83 shares per month (1,000 * 75% / 36 months). Here’s what that looks like:
Now, let’s look at a different example. This time, an employee is granted 5,000 stock options with a 3-year vesting schedule and a 1-year cliff.
The employee has zero vested options until after their first year, at which point they suddenly vest 33.33% of their options. The remaining shares will vest quarterly over the next two years at a rate of 416 shares per quarter (5,000 x 66.67% / 8 quarters). Here’s what that looks like:
In today’s world, switching jobs is common and has lost much of its stigma. With this in mind, is cliff vesting an effective retention method for employers? Let’s discuss.
Retaining valuable talent is especially crucial for startups and high-growth companies that rely heavily on skilled employees to drive growth and innovation and want to save costs on hiring and training talent.
On the one hand, cliff vesting can help incentivize employees to remain with the organization for a specific period of time and therefore reduce turnover. Workers, especially Gen Zers and Millennials, see many advantages (for instance, an increased salary and accelerating their career progression) to job hopping.
To retain talent, cliff vesting could potentially offset job-hopping incentives by encouraging employees to stay for a set amount of time. Employees may also feel that they have more skin in the game and feel motivated to work harder in order for the company (and their stock units) to do well.
On the other hand, cliff vesting as a talent retention method comes with its set challenges. It can make employees slack or coast until reaching their cliff vesting period. Employees who foresee a company takeover that poses a risk to their vested benefits may also feel disincentivized and therefore disengage.
And, if an employee leaves or a group of employees leave once their vesting period ends, it can create turnover when employees cash in.
In sum, while cliff vesting can be a powerful tool for encouraging longer tenures, its success depends on how well it’s balanced with other retention strategies and the overall company culture and environment.
The “cliff” is a specific period during which employees do not accrue any vesting rights, encouraging them to work for the company for a predetermined amount of time before their benefits begin to vest. A typical cliff period is one year, but it can vary.
This schedule means the employee receives no benefits for the first year of employment. After completing one year, 25% of the shares vest all at once; the remaining 75% vest gradually for the next three years. For more detail, see the “Cliff vesting examples” section.
Cliff vesting encourages longer-term commitment and reduces turnover, helping companies save costs. It also aligns employee goals with company objectives, making it easier for employers and employees to understand and plan around the vesting schedule.
Cliff vesting is commonly used in cryptocurrency, especially for token distribution in Initial Coin Offerings, Initial DEX Offerings, and other token launch events. Similar to traditional finance, the tokens are locked for a specified period before becoming available.
For example, employees who are offered team tokens on a four-year schedule with a one year cliff will receive no tokens until the cliff period is over; on their first work anniversary, 25% of the tokens immediately become available and the remaining 75% will vest gradually over the next three years.
Cliff vesting in crypto serves to protect early investors against market fluctuations, reduce market exploitation, offer token stability, and give developers time to build their product while maintaining investor confidence.
Cliff vesting is a widely used retention method for employers, especially as job hopping becomes the norm and companies look to retain talent for longer. While cliff vesting offers significant advantages such as simplicity, cost-effectiveness, and alignment of employee-company interests, it also has its set of challenges.
The potential for increased turnover risk after the cliff period and decreased employee morale due to lack of flexibility are notable drawbacks. Ultimately, the effectiveness of cliff vesting as a retention strategy depends on how well it is integrated with defined contribution plans, pension plans, and compensation packages.
As you brainstorm ways to retain top talent and structure your compensation plans, keep in mind that Rho can help you and your finance team maximize time for strategy. Focus on what matters most to you, like your retaining talent and creating a cliff vesting proposition, and leave the financial automation to us.
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Note: This content is for informational purposes only. It doesn't necessarily reflect the views of Rho and should not be construed as legal, tax, benefits, financial, accounting, or other advice. If you need specific advice for your business, please consult with an expert, as rules and regulations change regularly.
