Key takeaway

Equity incentive plans are frequently described to participants as a means of aligning them with the long-term success of the business. In practice, many plans do little more than measure the length of time an individual remains employed. That distinction affects how an award should be valued, how it should be communicated to participants, and how it should be treated for tax purposes.

This note considers the difference between vesting conditions that are calibrated to risk and those that are, in substance, retention arrangements presented in the language of ownership. It sets out why the distinction is important, and what boards and remuneration committees should be asking before an equity plan is put in place.

A vesting condition measures tenure. By itself, it does not measure the risk carried, the value created or the influence an individual has over the outcome. Retention and risk-sharing are legitimate but distinct commercial objectives, and plan design should not conflate them. A time-based cliff and a performance hurdle test different things. Treating one as a proxy for the other misrepresents what participants are being asked to accept. Where a plan is, in substance, deferred remuneration, it should be structured, taxed and communicated as such, rather than marketed as an ownership stake. Boards should be able to state, for any award, what a participant must do or what must happen in the business before the award produces value beyond the effect of time served alone.

What does vesting in an equity incentive plan test?

A standard time-based vesting condition asks a single question: has the individual remained in employment, or in office, for a specified period? It does not, without more, test whether the business has performed, whether the individual has contributed to that performance, or whether the individual has been exposed to any downside during the vesting period.

That is not a criticism of vesting as a mechanism. Restricting the transfer of value until a defined period has elapsed is a well-established and legitimate feature of share plans. It discourages early departure, gives a business time to assess performance, and is consistent with HMRC's expectations for tax-advantaged arrangements such as EMI options. The difficulty arises when a vesting schedule is relied upon, on its own, to justify describing an award as a genuine ownership stake.

Why can identical vesting periods carry very different levels of risk?

Two individuals holding awards with an identical four-year vesting schedule may have accepted very different economic positions. One may hold shares in a business carrying significant leverage, with debt and preference capital ranking ahead of the ordinary equity, and a hurdle that must be cleared before any value accrues to that class of share. The other may hold options over a stable, ungeared business with no performance condition at all. The vesting period looks the same on paper. The risk carried by each individual is not.

For a broader discussion of employee participation in ownership structures, see our recent article on the benefits of Employee Ownership Trusts.

Why are retention and risk-sharing different objectives?

There is nothing improper in a company wishing to retain key employees, and equity is a well-recognised tool for doing so. A vesting schedule that simply defers the transfer of value to encourage continued service is, in substance, a retention arrangement. It can be an entirely appropriate one.

Difficulties tend to arise where such an arrangement is described to participants in the language of ownership or partnership, for example, where employees are told to “think like an owner” without any corresponding transfer of economic risk. If the individual’s award will pay out on the same terms regardless of the company’s performance during the vesting period, the arrangement is closer to deferred salary than to risk capital, and the documentation and internal communications should reflect that.

What is the difference between a vesting cliff and a performance hurdle?

A performance hurdle asks whether value has been created above an agreed baseline before a participant is entitled to share in it. A time-based cliff asks only whether a period has elapsed. The two are frequently used together, but they should not be treated as interchangeable, and a plan that relies solely on the cliff, without any hurdle or comparable performance condition, should not be described to participants as a performance-based arrangement.

How do good and bad leaver provisions affect equity incentives?

The position is often compounded by good and bad leaver provisions, which determine what a participant retains on departure. Where these provisions are drafted broadly, for example, treating almost any departure other than dismissal for cause as a bad leaver event during the vesting period, the practical effect is to strengthen the retention function of the plan while doing nothing to increase the participant’s genuine exposure to business risk. Boards should consider whether leaver provisions are calibrated to a legitimate commercial concern, such as protecting confidential information or client relationships, rather than simply extending the period over which departure is penalised.

Good and bad leaver provisions can also become contentious in wider corporate arrangements. Our article on family business governance and dispute risks considers the interaction between employment status and ownership rights where leaver provisions apply

Why does equity incentive plan design matter more in a slower market?

In a rising market, the difference between a genuinely risk-calibrated award and one that functions merely as a retention arrangement is rarely tested, because valuations tend to increase regardless of how the award was structured. That difference becomes material when growth slows, exit timelines lengthen, or a funding round is completed at a flat or reduced valuation.

Many private companies are currently operating in exactly that environment, with longer holding periods and less predictable exit routes. Where an employee has served out a vesting period in full and receives little or nothing of value at the end of it, that outcome is not usually evidence of an unfair plan. It is often the predictable consequence of a plan that was calibrated to time rather than to risk and was described to the participant as though it were the latter.

For companies preparing for an exit, option schemes and historic share issuances will also form part of the buyer’s review of the company’s shareholding structure. See our article on how to prepare a UK SME business for sale.

What should boards and remuneration committees consider when designing equity incentive plans?

Before an equity incentive plan is adopted, or an existing plan is renewed, boards and remuneration committees should be able to answer the following, in respect of each category of award:

• what must the participant do, or what must happen in the business, before the award produces value beyond the effect of the vesting period alone?

• where the answer is, in substance, nothing beyond continued service, is the award appropriately characterised, documented and taxed as deferred remuneration rather than as an ownership interest?

• are good and bad leaver provisions calibrated to a legitimate business interest, or do they function principally to extend the retention effect of the award?

• are communications about the plan, including template letters, staff presentations and offer documentation, consistent with the legal and economic substance of what has actually been granted?

Are time-based vesting conditions enough on their own?

None of this suggests that time-based vesting should be abandoned. It remains a legitimate and, in most cases, necessary feature of share plans. The point is a narrower one: a vesting period tells a company how long an individual has remained in post. It does not, on its own, tell a company or its employees anything about risk, and it should not be described as though it does.

Barnes Law’s Corporate team advises companies, founders and shareholders on equity incentive arrangements, share structures, employee ownership and wider corporate governance matters. For more information, please contact our boutique corporate lawyers to discuss how we can support you.

Written by Barnes Law Managing Partner Yulia Barnes.