I have not written about options in a while, but a post by Fred Wilson has led me to want to make a couple of points.  Before I start in on the points I want to make, in fairness to Fred Wilson, as he himself points out, he has barely dipped his toes into this topic and he plans many more posts. 

With respect to vesting, Fred has the following to say, “Vesting usually happens over a four year term, but some companies do use three year vesting.”  It is true that in the case of venture funded companies the “norm” is four year vesting with a one year cliff, but I rarely see three year vesting.  (Right now, I don’t recall ever seeing it in the context of a “normal” option grant for a venture financed company.)  I don’t mean to quibble, by I have noticed a trend to the other end.  There are at least a couple of VCs (one in Boston and one in Silicon Valley) that I know use five year vesting with a one year cliff.  Anecdotal information suggests that this practice is gaining ground. 

The reason for this trend, if it is a trend, is that VCs want to more precisely align the payoff to the option holder with the liquidity event (exit) for the VC.  As it turns out, many very high quality venture funds have average holding periods for investments of north of 8 years.  That is to say that, on average, it can be 8 years (or more) from the closing of the first investment to the exit.  During that period, many employees can vest large piles of options, and (at least in theory, and to be fair, often in practice) leave the company, exercise their options and take their talents elsewhere.  Top re-incentivize these employees, it may become necessary to “reload” option packages from time to time.  This practice, of course, can be expensive.  And, if the employee leaves and has to be replaced, the replacement will need an option package.

I understand this thinking, but I am not a big fan of five year vesting.  Although, I don’t think there is a principled reason to pick 3, 4 or 5 (or any other time frame for that matter), here are is a reason why I don’t like it.  First, in the tech world five years is an eternity – hell four years is an eternity.  It makes the brass ring harder to see and less tangible.  In effect it diminishes the incentive value. 

Many employees are great for different stages of a company’s development.  So, the guy who did product development at the start and was great with a team of two engineers can’t run a team of twenty.  He added great value for a period in the company’s development and then had to be replaced.  Only a few employees will really make every transition (admittedly some will). 

The compensation, including the incentive compensation, needs to dovetail with the expected performance not with the VC investment horizon.  (Just to make an exaggerated point, if vesting were to be keyed to the investment horizon, then the early employees might be looking at 8 year vesting and the later ones 2 year vesting.)  I can hear VCs saying we expect everyone to grow with the company etc. anyway how do we know we only want Harry for four years when we hire him but we want Sally for five?  What signal would varying vesting schedules send?  And so on.  We need a one size fits all solution…

So why 4 years?  Well, this amount of time seems to represent a compromise of sorts between wanting the liquidity to be consistent with liquidity and wanting it to be consistent with the relevant term of the services provided.  It seems to work in most cases.  So, before you buck the trend, you should have a good reason because if you go for a longer period you will undermine the value of your options to your employees and will make it harder to hire and keep them.  If you go for too short a period, you run the risk of undermining the incentive to stay.