Vesting

Young companies often give employees the option to take ownership in the firm through distributing equity in the form of employee stock options. These stock options are considered a part of the employee’s compensation for the year, and therefore it is paramount that they understand the implications of such instruments. In this paper we will describe a key characteristic in many option grants: vesting.

Vesting is the manner in which an employee is able to earn an asset. In this case, the asset is the underlying common stock outlined in the grant.

The idea behind vesting is that an employee must wait for a certain period of time before he/she is able to exercise the option and receive the underlying common stock at the agreed-upon strike price. The reason many companies employ this policy is to incentivize employees to continue working at the firm and continually produce good results.. It aligns employee and company incentives to work hard to raise the overall valuation of the firm. This should result in larger proceeds for the employee when he/she eventually exercises and sells their shares.

Vesting breakdown

As mentioned before, companies grant stock options (such as ISOs and NSOs) to employees as a part of their compensation package. A full blog post on these is linked here. This means that employees haven’t actually received any stock as of the grant date, but rather they have the ability to purchase stock at a predetermined price in the future. However, with options that vest, the employee must wait for his/her options to vest before exercising his/her right to purchase.

Typically, the board of directors that creates the employee stock option plans creates what is called a vesting schedule, which outlines the exact date and amount of options that vest. These vesting schedules dictate when employees can exercise (purchase) their earned options and receive stock. In general, there are three types of vesting schedules that are used by companies: time-based, milestone-based, and a mix of the two.

Time-based vesting schedules

The concept of time-based vesting is very intuitive. Over a set period of time, a certain amount of stock options will vest (or become available) to the holder to exercise. A common feature of time-based vesting schedules is the inclusion of a “cliff,” which represents a period of time after which the first section of a holder’s stock options vest. Typically, following the cliff, the remaining stock options from the grant will vest at a steady rate until the entire grant has vested.

The most frequently used cliff by many companies is a one-year cliff. This strategy by management forces many employees to stay at the firm for a minimum of one year before any options are exercisable, thereby creating a more focused work environment. If an employee decides to leave before this cliff, he/she will be unable to exercise, with the options going back into the larger group of options to be distributed to other employees.

A normal four-year time-based vesting schedule with a one-year cliff will be structured such that a quarter (1/4) of the shares will vest after one year. Following the cliff, 1/36 of the remaining shares will vest each month until the four-year period has ended. This means that after four years, all stock will have been vested and the holder can freely exercise at his/her will.

Additionally, there is typically a term limit of 10 years that the holder has to exercise all of his/her vested stock if he/she remains at the company, and this term of 10 years begins on the grant date.

Milestone-based vesting schedules

Milestone-based vesting schedules are exactly what you might figure: vesting based upon completing certain projects, or in other words, reaching specific company milestones. This type of vesting schedule is very goal-oriented and is intended to incentivize the grantee to perform at a desired level and bring the company to a specific state.

A common example might be that options will vest once the company has reached a certain valuation. In theory, this proves that the employee is doing a good job and is therefore rewarded with the ability to purchase equity in the company.

These types of vesting schedules might get very hairy if the conditions are not described in extremely precise detail. If ambiguity exists, there may be room for subjectivity which could lead to potential lawsuits between the employee and the firm. Therefore, an employee granted options in such a contract must understand each condition with great clarity for best results.

Mixed vesting schedules

Mixed vesting schedules are fairly straightforward in theory. They are just a combination of both a time-based vesting schedule and a milestone-based vesting schedule. In effect, an employee with a mixed schedule must work at the firm for a specific amount of time to satisfy the time-based component as well as achieve the prescribed goals set forth in the grant contract to satisfy the milestone component.

Example

Suppose that company ABC distributed an option grant to a newly hired employee on January 1, 2019. The details for the grant are outlined in the table below:

For this employee, they will not be able to exercise any of his/her shares until the one-year cliff has been reached. After the one-year cliff on January 1, 2020, (1/4) of the shares (180) will now be eligible for exercise. Over the next three years, for each month, (1/36) of the remaining shares, or (1/48) of the original shares will vest and be eligible for exercise. This equals 15 shares each month, until the  entirety of the remaining 540 shares have vested.

The chart below depicts this vesting schedule:

Summary:

• A vesting schedule delineates the amount of time a person must wait to exercise their stock options at a prescribed strike price
• There are 3 different types of vesting schedules: time-based, milestone based, and mixed
• A mixed vesting schedule is combination of both a time-based and milestone based vesting schedule

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