Stock vesting: Why is four the magic number?

(Editor’s note: Jeff Bussgang is a General Partner at Flybridge Capital Partners. This column originally appeared on his blog Seeing Both Sides.)

There’s a historical anomaly in start-up compensation that I’m struggling with.  Although I know this risks being an unpopular post with entrepreneurs, I confess that I no longer get why we have four year vesting schedules for stock option grants at start-ups.

Let me explain.

Vesting is known as the time period during which you unconditionally own the stock options that are issued to you by your company.  Until you vest the stock options, you forfeit them if you were to leave the company.  Typically, that time period is four years.

There is also generally a one year “cliff”, which means that you don’t vest for a year and then “catch up” by vesting 25 percent of the stock options on the one year anniversary.  Subsequent vesting happens monthly or quarterly, depending on the stock option plan your company has put in place.

I was explaining to a friend the typical vesting at venture capital firms is 8-10 years.  That is, if you leave a fund before 8-10 years from the start of the fund, you risk forfeiting some of your unvested profit interest in the fund, or carry.  I explained to my friend that this vesting schedule made sense given venture capital funds take 8-10 years from managing initial investments through to exits.

Then I realized that vesting at start-ups should also logically match the time it takes from inception to exit.  In looking at the data, it appears that the average time to exit in start-ups during the 1990s was 4-5 years, so the traditional 4 year vesting period made sense.

But since then, the average time to exit has crept up meaningfully from 4-5 years to 6-8 years.  So shouldn’t vesting schedules reflect this reality?  Shouldn’t the vesting schedule for stock options be 6 years?

Boards are finding that they have to reissue options every 3-4 years because once an employee is fully vested, they naturally come back to the table with their hand outstretched asking for more incentive options to stick around.

In fact, why can’t vesting schedules be flexible and simply a part of the overall compensation negotiation?  A CEO would benefit from having the tools at their disposal to adjust vesting dates alongside share amounts and other compensation levers.

For example, in the very early days, you might have six year vesting on stock options – but after a few years, that date might be reduced to four or five, depending on the situation.  Some form of accelerated vesting upon change of control (i.e., a sale) is often a part of the package for senior executives, so if a quick exit were navigated, there wouldn’t be a meaningful penalty.

So maybe you can explain it to me, but I just don’t get why our industry clings to a historical magic figure of four years. Leave your thoughts in the comments below.

(Image courtesy of the New York State Society of CPAs)