TL;DR
A cliff refers to a specific period at the beginning of an equity vesting schedule during which no shares or stock options are vested (typically, this period lasts one year).
If an employee or founder leaves the company before the cliff period ends, they do not receive any equity. Once the cliff period is completed, the individual is granted a lump sum of the equity they would have vested during that time. After the cliff, equity continues to vest gradually according to the vesting schedule.
How Does a Cliff Work?
To better understand how a cliff works, let’s break it down:
1. Equity Vesting Schedule
When a startup grants equity to employees, founders, or other stakeholders, it usually follows a vesting schedule.
A common vesting schedule in startups is four years with a one-year cliff. This means that the equity is distributed over four years, but no equity vests until after the first year (the cliff).
2. The Cliff Period
During the cliff period, which is typically one year, no equity vests. If the individual remains with the company through the entire cliff period, they “hit the cliff” and receive a lump sum of the equity that would have vested during that time.
For example, if someone has a four-year vesting schedule with a one-year cliff and is granted 48,000 shares, they would receive 12,000 shares (one-fourth of their total grant) after the cliff period ends.
3. Continuous Vesting After the Cliff
After the cliff period, equity vests continuously—usually on a monthly or quarterly basis—until the entire grant is fully vested by the end of the vesting schedule.
Importance of a Cliff in Startups
The cliff serves several important purposes in the context of startups:
- Protecting the Company: The cliff protects the company from having to distribute equity to employees or founders who leave early. Since no equity vests until the cliff period is completed, the company retains ownership of the shares if someone departs before the one-year mark.
- Commitment Check: The cliff period acts as a commitment check for both the company and the employee or founder. It ensures that those who receive equity are committed to staying with the company for a meaningful period before they start vesting equity.
- Simplified Equity Management: The cliff simplifies the process of managing equity grants. Instead of dealing with small increments of vested equity during the initial months, the company only needs to account for the equity after the cliff period is reached.
Example of a Cliff in Action
Let’s consider a fictional startup, Tech Innovators Inc., and its equity vesting structure for a new employee:
- Total Equity Grant: 48,000 shares
- Vesting Schedule: 4 years
- Cliff Period: 1 year
Scenario: Employee Stays for 2 Years
- End of Cliff Period (1 Year): After the first year, the employee “hits the cliff” and vests 12,000 shares, which is one-fourth of the total equity grant.
- Ongoing Vesting (2nd Year): Over the next year, the employee vests an additional 12,000 shares (1,000 shares per month), bringing the total vested equity to 24,000 shares at the end of the second year.
Scenario: Employee Leaves Before 1 Year
If the employee leaves the company before the one-year cliff period ends, they do not vest any equity. The company retains all 48,000 shares, and the departing employee walks away without any ownership stake.
Conclusion
The concept of a cliff is a fundamental aspect of equity vesting in startups, serving to protect the company and ensure that equity is granted to individuals who are truly invested in the company’s future.
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