Like most things when it comes to options, there is no rule you absolutely must follow when it comes to vesting schedules and the manner in which vested options are exercised. But before we dive in, let’s go over the difference between vested and unvested options.
Options will vest (i.e., become excercisable) over a period of time known as a vesting schedule. In other words, if an option has not yet vested, it cannot be exercised.
Creating a Vesting Schedule
When the board approves a grant of options to someone, the resolution approving the grant (or the grant document approved by the board) should set out the period of time over which the options will vest. Typically, there is a one year cliff, a full 12 months during which no options vest until the very end of that period. At that point, we usually see about 25% of the options granted vest. After that initial cliff, the usual approach is that the balance of the options vests on a monthly basis, in equal and consecutive tranches. The logic behind the cliff is that you don’t usually want someone who stays less than one year with your company to have the benefit of any equity.
Let’s put some numbers around this. Say you have 1,000 options which have been granted on day 1, and we want them to vest over a 4 year period (i.e., 48 months). After 12 months, 250 options (i.e, 12/48ths) will have vested. And at the end of every month following month 12, 20.83 options (i.e., 1/48th) will vest.
But like I said, this isn’t a rule. If you want to have the options vest annually over 3 years, you could do that. If you want the options to vest every 6 months over 5 years, you could do that too.
Option plans will vary on this point – some plans will allow an option to be exercised once they have vested, others will provide for a “double trigger”, i.e., the options must have vested and there must be a liquidity event.
Under the first scenario, you could have an option holder who has a small amount of options exercise those options, pay the exercise price, and get shares in exchange. That means you could have someone who has a very small amount of equity who all of a sudden has rights as a shareholder. So be careful if you go with this approach. Consult your lawyer, and make sure you have the right paperwork in place to protect the company. Keep in mind that shareholders have rights under the law.
Under the second scenario, the company has to usually be up for sale. Meaning, even vested options can’t be exercised until the sale is imminent. Here’s how this would typically work:
- A buyer makes an offer to the company’s shareholders which they accept.
- The board notifies the option holders of the impending sale.
- The option holders then complete an exercise form and exercise any of their vested options.
Note that unvested options are usually cancelled and not part of the sale. If your company wants to allow unvested options to be sold, you’ll need a board resolution to do so. The board would say that the unvested options are “accelerated” and therefore all vested.
There are some nuances around cashless exercises of options, but that’s a technical point. In fact, you should check your option plan to see if it provides for it. If you’re wondering how that functions, consult your lawyer.