I hear nowadays that to reward an employee the norm is to give out equity in the form of stock options with a 1 year cliff and 4 years vesting. Is this fair and reasonable?
I can understand what you are trying to achieve but I'm not sure that it doesn't raise just as many questions.
Example one: I don't really understand this point at all. The value of the equity is certainly questionable at the early stage of a company, but investment valuations provide some level of benchmark beyond profits. If those valuations are good enough for parties committing money, they should serve as a good measure of equity value.
Example two:It would be extremely unusual to have an accelerated vesting provision in a incentive program. During a buyout or new round, it's true that the company could accelerate vesting in a way that is unfair to some employees but typically it's handled in a way to both reward employees and incentivize staying with the company. Full acceleration of an employee's equity creates a risk to the company. It should be noted that unvested or unallocated shares at the time of a purchase would fold back into the company and as such distributing it indiscriminately would be unfair to shareholders as well as employees.
Example three: True, but I've never seem anything that didn't incentivize employees to stay with the company.
Example four: I don't see the connection between vesting and dilution. A company's employee incentive program will represent a percentage of equity and allocating shares willy-nilly or not has no dilutive impact. That said, during a new round investors could push to reduce the size of the incentive program thus diluting employees. But once again, that's a issue of equity allocation not the vesting model.
Example five: That's true. Employers could terminate employees the first year without cause and employees could leave just after initial vesting. To model an incentive program you have to assume that the goal of both parties is to have a successful relationship. Equity is not compensation and shouldn't be treated like it is. Not every employee that walks in the door should be elevated to the status of shareholder. That would create a huge drag that would prevent the company from rewarding those that contribute. A vesting system allows employees time to prove their value to the company. It's called an incentive program for a reason. You earn equity by contribution, you receive equity by commitment.
Example six: There is rarely a cliff in an employee's vesting. You're continually awarding more equity to valuable and contributing employees and that follow on equity starts vesting immediately. We also have to realize that lives change and people move on for reasons that aren't connected to the company. The vesting model allows employees to make decisions about their future with the company.
As for the split at the outset, I agree that there might be better ways to structure the initial common stock distribution but that problem is separate from the employee incentive programs. It sounds to me like we're combining two issues that are tangentially related.
It's good topic and a discussion on how to fairly award equity or measure contribution would be a great followup.
I'm always up for reading something new.