What Is Vesting Stock?
Vesting is a legal term that refers to acquiring a right to a present or future payment or asset.
With respect to employee compensation, vesting stock is a form of equity compensation in which the recipient derives the right to receive future shares of a company's stock, but does not actually acquire ownership of any shares until a vesting event occurs.
Employees are granted these stock options as part of their compensation plans. Consequently, the employee must meet certain targets to gain the right to gain shares.
A company can grant vested stock either through Employee stock options (ESOs) or Restricted stock units (RSUs).
What is the purpose behind companies offering Vested Stock Options?
1. Availability of cash
Since most small and startup companies don't have enough revenue or cash flow, companies offer vested stock options instead of cash bonuses. Cash can instead be used for other crucial purposes such as hiring new employees or paying off debts.
2. Employee loyalty and lower employee turnover
Retaining employees is a crucial part of running a business. When an employee is happy and satisfied with his or her job, it's very likely that they will continue to work for the company for years to come and be a valuable asset. In order to avoid losing employees, companies offer vested stock options.
Companies use vested stock to attract employees by promising a certain number of shares in a certain time period. The vesting stock is a form of deferred compensation.
Vesting stock has been adopted by companies to ensure that their top employees remain with the company for the long term. It is called vesting stock because the stock vests or gets released slowly over time to the employee. The time period during which the option vests is called the vesting period. A common vesting period is three to five years.
The idea behind vesting is that employees are motivated to stay with the company for a set period of time to receive the full benefit of stock options received as an incentive for their hard work.
The vesting stock gives a startup a way to attract and retain a talented team by encouraging employees to stay longer. If a person leaves a company before a vesting period ends, the company has the right to forfeit any unvested shares.
In some cases where an employee has been with the company for many years, the value of their vested stock option may exceed their annual salary. Therefore, this type of incentive is attractive because it provides a better opportunity for income and retirement savings.
What happens when Stock Options vest?
As soon as all the options have vested, the employee can exercise his option and purchase the actual shares of the company at the original strike price.
For example, say your company has given you 1000 options at a price of $ 1 over a 3 year period. After you have completed the term, you can purchase the shares of your company at the initial price of $1, even if the fair market value of the shares is much higher today. These could be even $20 or $30 dollars a share.
Types of Vesting Schedules
Vesting is a common way to motivate employees. The vesting schedule varies from company to company along with other terms and conditions. Vesting schedules are categorized into three types: time-based, milestone-based, and a hybrid of time-based and milestone-based.
Time-based vesting is a method of vesting in which an employee’s vested percentage is based on time instead of performance. It is the most commonly used form of vesting in startups.
Stock options are earned by employees over time, usually based on a set schedule and a cliff.
Essentially, the cliff is the point at which the employee's first option becomes exercisable. Companies typically grant option grants with a one-year cliff. Therefore, if an employee needs to exercise any options, they must stay at the company for at least a year.
The longer an employee stays with the company, the more shares vest. However, if an employee leaves before reaching the required vesting time, the employee does not get to own those shares. Any unvested options get put back into the option pool when the employee leaves (and after the post-termination exercise period has elapsed).
Vesting schedules vary between companies. Some companies give their employees 10% of the shares in the first year, 15% in the second year and so on. Others use the reverse method, offering a higher percentage of shares in the first few years to make it more employee-friendly.
In many cases, stock options are granted with a vesting schedule of four years and a cliff of one year. After reaching the cliff, the remaining stock options are gradually issued each month or quarter, depending on the vesting schedule. At the end of four years of service, the employee will have fully vested shares.
Example of time-based vesting
Kate plans to join a startup as a new employee. As part of her compensation, she will receive a total of 1000 shares over the next four years with a one-year cliff.
Jane would receive her first 200 exercisable stock options after completing her first year of employment. Following that, she would receive 66.66 shares every quarter for the next 3 years. This would give her 1000 overall shares of the company at the end of the 4 year period.
Milestone-based vesting, as the name suggests, refers to the method of vesting where the employees receive their stock options or shares after completing a certain milestone or when the company reaches a business goal.
This could be events such as the signing of a revenue-generating contract, the successful launch of a new product or the completion of a product development milestone.
In contrast to a time-based trigger, the vesting of these shares is triggered by the employee's accomplishments or goals. In this way, the employees are kept focused on the goals and rewarded for successfully completing them.
Example of Milestone-based Vesting
Anne works as a sales executive for a software company. The company is willing to grant Anne 100,000 shares of company stock if she hits a sales target that she and the company agree upon. Upon reaching this milestone, a certain percentage of her stock will vest immediately, while the rest will vest over time over a vesting schedule.
Hybrid vesting is a combination of the two vesting methods - time based and milestone vesting.
In this method, employees must work at the company for a certain amount of time and also reach certain goals in order to receive options or shares.
Example of hybrid vesting
Anita is employed as a software developer for a fintech startup. In addition to her salary, she has been offered stock options that have a hybrid vesting schedule.
Anita would receive 400 shares of the company spread over three years with a one-year cliff.
As soon as Anita completes her first year of employment, she will receive her first 100 exercisable stock options. She would then receive 12.5 shares every month for the next two years. At the end of the three year period, she would have 400 shares of the company. In addition, if she accomplishes an important product feature, she will be rewarded with 100 shares. This means that in total, she would receive 500 shares, as her company follows a hybrid vesting schedule.
Difference between Cliff, Graded and Accelerated Vesting
- Cliff vesting: In this method, no vesting occurs until the full amount has been earned. This is the most risky for the employee, but the least risky for the employer.
- Graded vesting: Graded vesting schedule is when an employee will get a percentage of their equity after a certain amount of time. This is the most commonly used vesting schedule.
- Accelerated vesting: Vesting can occur rapidly during the first few years (often 5-10% per quarter). This is the most beneficial for the employee and the least beneficial for the employer.