What Does Cliff Vesting Options Mean?
Cliff vesting options provide the holder the option (but not the obligation) to acquire the shares of a company at a specified strike price. In essence, they have the same attributes as regular options with one exception: they all vest, or "cliff," at a specific time rather than the vesting period being amortized over the life of the term. For example, a holder of 3,000 options that cliffs in three years would see them vest in their entirety once the three years are up, rather than having 1,000 vest every year for the three years.
Divestopedia Explains Cliff Vesting Options
Options, in general, provide the issuer with excellent leverage because they represent "value" or "compensation" without having to issue actual shares. Cliff vesting options are even better leverage because the cliff vesting period can be tied to a specific event, such as a liquidity event.
Private equity firms typically use cliff vesting options as part of their original transaction structure because they are perceived by the seller to have value. If there are some adjustments done to the purchase price after due diligence, cliff vesting options can be used as a way to keep the deal on the rails.
An even better use of cliff vesting options by private equity firms is to offer them to management part way through the investment life cycle in order to entice management to stay until the investment is sold. This keeps their motivation up, as they can see a big pay day if they can assist the PE firm sell the business within, say, three to five years. For example, if the private equity firm is looking to monetize in three years, the options would "cliff-vest" in three years, therefore, aligning the time horizons.