A stock option gives an option holder the right to buy a set number of shares at a fixed price. To encourage employees to stay with a company longer, employees, contractors, and consultants have to earn the right to purchase the shares over time. Earning the right to purchase shares is called vesting, and vesting occurs over a certain time period. This time period is called a vesting schedule.
There are three types of vesting schedules: time-based, milestone-based, and a hybrid of time-based and milestone-based.
Most time-based vesting schedules have a cliff. A cliff is when the first portion of an option grant vests, which is usually at the one-year anniversary of a startup employee's initial employment date.
Under a standard four-year time-based vesting schedule with a one-year cliff (which corresponds to 48 total months of vesting), 1/4 of the option holder's shares will vest after one year. After the one-year cliff, 1/36 of the remaining granted shares will vest in each successive month until the four-year period is over. At this point, the employee would be fully-vested.
With milestone vesting, vesting is triggered by completing a specific project or reaching a business goal. Hybrid vesting is a combination of time-based and milestone vesting.
Vesting in practice
A simple example will illustrate the vesting process. Meetly, Inc. hired Kerri on November 1st, 2017. As part of her compensation package, Meetly gave Keri an option grant (dated 11/1/2017) for 192 shares that vest over four years, with a one-year cliff.
One year after Keri's hire date, on November 1st, 2018, she reaches her cliff and 1/4 of her shares (48 shares in total) vest. She can now exercise those 48 shares.
Over the next three years, an additional four shares will vest every month. By Nov 1st, 2021 Keri will be completely vested and can exercise and purchase all 192 of the shares in her option grant.
If she leaves the company before Nov 1st, 2021, Keri will surrender all unvested shares, which will be returned to the company's option pool.
And those are the basics of vesting.
For a more thorough explanation of strike prices, option pools, and other complicated equity concepts that affect startup founders and employees, see our full guide here.