Vesting is the percentage of equity each owner receives. Vesting cliffs are designed to prevent situations where another owner’s early departure can disrupt the company, leaving the remaining owners unfairly burdened.
Essentially, a vesting cliff is like a trial partnership. You agree at the outset – usually in the Operating Agreement – what percentage of equity each owner will receive and what the vesting period will be. However, it’s also stipulated that if they quit or get terminated at anytime during the vesting period, then the departing owner is prevented from collecting any equity.
For example, let’s say you and your partner decide on a four year vesting period. That means each year, you earn 25% of your interest; after four years, you’re fully vested at 100%. However, to avoid anyone from realizing any gains too early, you both agree to a one year cliff period. If you or your co-owner exits the company before one year, the leaving person loses 100% of their equity. If they exit after one year, but before two years, they can collect 25% of their equity; 50% after two years; 75% after three years; and finally 100% at the end of four years when they become fully vested.
Vesting cliffs are also used when offering new employees stock options. These agreements invariably include vesting cliffs, usually for one to two year period. As in the scenario above, if an employee is offered stock options, they must remain employed with the company for the minimum cliff period before their stock equity vests.
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