Cliff Vesting: Everything You Need to Know
Cliff vesting is the process where an employee is fully vested on a given date and receives their full benefits of the retirement plan on a specific date.5 min read
2. The Different Types of Vesting
3. Why Is Cliff Vesting Important?
4. Reasons to Consider Not Using Cliff Vesting
5. Reasons to Consider Using Cliff Vesting
6. The Differences Between Defined Benefit and Defined Contribution Plans
Updated July 27, 2020:
What Is Cliff Vesting?
Cliff vesting is the process where an employee gets fully vested on a given date. The employee receives his or her full benefits of the retirement plan on a specific date instead of in amounts over time. The "cliff" described is the date on which you become fully vested. A four-year vesting schedule with a one-year cliff is common.
Cliff vesting is the way that employees of a company can acquire full ownership of incentives or assets of the company's qualified retirement plan account on a specific, agreed-upon date, instead of over a longer period. This period cannot exceed six years. The "cliff" is usually one year in.
Companies put vesting schedules in place as a way to handle pension or retirement plans. There are other assets and benefits that can be specified. But they must meet the minimum vesting standards that the IRS outlines. These schedules are often used as a way to reward loyal employees. They have a large impact on the employee's equity package and how much it can be worth it.
Example: Vesting means that instead of receiving our money or assets immediately, we get them over a period of time. It is common to receive them for over four years.
- Year One: 25 percent
- Year Two: 50 percent
- Year Three: 75 percent
- Year Four: 100 percent
The equity package an employee receives can be generous, but he or she should finish his or her vesting schedule. Otherwise, the employee could lose his or her benefits. Nonforfeitable rights are dependent on the length of time an employee has worked with the company. Cliff vesting does not pay out partial benefits.
Cliff vesting allows you to try out a partnership without having to commit right away. You will agree upon the amount of equity and the length of your vesting schedule. But it wouldn't apply if you left the company before the end of the cliff period.
Example: Let's say Sally works at Company X, which participates in a qualified retirement plan. Her plan lets her contribute up to 7 percent of her annual salary, before taxes. Company X will match Sally's contribution by up to 7 percent of her pre-tax salary.
During her first year with the company, Sally contributes $7,000 and Company X also contributes $7,000. Her fund totals at $14,000, but if Jane leaves within that year, she only has ownership of the $7,000 she contributed.
The Different Types of Vesting
The way vesting works depends on the included assets, such as stock or options. When we speak of options, this means you can be given a certain amount of options, which will not be available until you vest. Once your vest, you will have the option to purchase certain shares at a specific price during a pre-specified time. Once you are vested, the stock is issued to you in its entirety. You own all of it. However, any unvested amount is available for the company to repurchase.
- Graduated Vesting: These represent accelerated benefits. Employees receive them as their time at the company grows.
- Graded Vesting: Employees receive a percentage of rights over contributions the employer makes to their retirement plan. This happens each year until they become vested. The percentage increases each year.
Why Is Cliff Vesting Important?
Cliff vesting is the provision of vested benefits at a certain date. A vested benefit is an incentive that employers can offer their employees. It is usually financial. This benefit can give employees an incentive to become part of the company long-term. It creates an environment of loyalty and decreases turnover.
Options represent "value" and "compensation" without a need to issue actual shares. The importance of cliff vesting options lies in the fact that the cliff vesting period can be formed with a specific event in mind. Vesting can have some drawbacks. One is that many people can each own a percentage of the company. This makes legal processes more difficult in the long run, and it is what cliff vesting was designed to solve.
Reasons to Consider Not Using Cliff Vesting
Cliff vesting creates uncertainty for an employee. They take a chance that their employer may fire them before the cliff vesting date. Sometimes if an employee is average and closer to the cliff vest date, management may decide to let him or her go. It is especially uncertain when signing on to a startup. The reason being is because many startup companies tend to fail within the first three years.
Cliff vesting can be problematic if the company goes through a sale during the first year of employment. The cliff may not apply in the event of a sale.
Companies that are backed by buyout firms aren't used to sharing equity with their employees. They usually have unfair vesting practices. Sometimes, certain clauses can be included in an option agreement that doesn't benefit the employee. For example, employees may be required to stay employed during the entire liquidation or sale of the company. If they left the company beforehand, they wouldn't receive their vested share.
Reasons to Consider Using Cliff Vesting
One of the most exciting aspects of joining a startup as an employee is getting stock options. Stock options are a method to achieve ownership of the company. Employees and an employer's incentives are closely aligned at this point.
However, the main issue with regular vesting is that you could have too many people at the company, each owning a small percentage of the company. Therefore, the employee and employer feel stuck with each other, not truly happy if either wants to end the working relationship. This is what makes cliffs so attractive.
Cliff vesting allows the employer a way to recruit employees who can bring value to their company. For example, if an employer wanted to make someone comfortable or gain his or her trust, the employer might offer a shorter cliff.
Hiring managers see cliff vesting as a process that ensures company stock is only going to employees who are aligned with their financial goals.
The Differences Between Defined Benefit and Defined Contribution Plans
Once an employee becomes vested, the benefits the employee might receive depends on the details of the retirement plan the company offers.
- Defined Benefit Plan means the employer has to pay a certain amount to the employee each year. This amount is based on the employee's last year of salary, his or her years of service, and other factors.
- Defined Contribution Plan means the employer has to pay a certain amount into the plan. But it doesn't have a set amount the employer must payout to the former employee. The former employee's payout depends on how the assets perform investment-wise.
As an employee, when getting closer to your cliff date, your performance should definitely be key. You don't want to be let go from the firm just moments before being fully vested. This is something many employers keep a watch out for, especially startup companies. They do not want to lose their employees immediately after the cliff date, where they can take their shares and leave.
If you need help with figuring out cliff vesting, you can post your question or concern on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience. They have worked with or on behalf of companies such as Google, Menlo Ventures, and Airbnb.