Equity compensation is getting popular no matter the size of the business. When you give employees stock as part of their compensation package, you of course want it to be attractive to employees and at the same time beneficial to your company.
So, stock vesting is an important component to consider when planning equity compensation because it determines employee retention.
In this post you’ll learn:
What is vesting?
Vesting is the process of gaining 100% ownership of an asset. When employees are granted an asset on day one, they don’t have full control over it until the vesting period has passed.
Once it has passed, they fully own the asset and can exercise (i.e. purchase) and/or sell it.
How does vesting work?
Vesting works by setting up criteria for becoming an owner of an asset. If the criteria aren’t met, the stock is not yet vested completely to earn it. There’re mainly three vesting criteria – milestone-based, time-based (more common) and a combination of both. Let’s look at the following examples:
– Milestone-based vesting: A recipient will be able to earn his/her asset when the company accomplishes a project, e.g. IPO, or he/she achieves performance targets.
– Time-based vesting: Stock options are typically time-based. If an option has a 3-year vesting period, the recipient will need to wait 3 years to receive his/her options based on its vesting schedule which might be cliff vesting or graded vesting.
– Hybrid vesting: Vesting for restricted stock units (RSU) is usually hybrid in private companies.
A vesting schedule heavily determines the attractiveness of equity compensation and the effectiveness of staff retention. Speak with us today if you have any questions about vesting.
Vesting schedules: Cliff vesting, Graded vesting & Immediate vesting
In cliff vesting, employees have to complete a designated time period in the organization before they can become fully vested to receive the asset. In graded/ratable vesting, they’re gradually entitled to a bigger percentage. Immediate vesting is not as common as the other two because it doesn’t require a recipient to wait before getting the equity ownership.
Full Year(s) of Service
Cliff vesting (over 3 years)
Graded/ratable vesting (over 6 years)
It’s a process where employees receive full award ownership. Imagine you offer your employees 300 shares of stock options with a 3-year cliff vesting schedule. This means they cannot exercise (i.e. purchase) them until 3 years later. After 3 years, they can exercise them at the initially agreed price (i.e. exercise price) and sell the vested shares.
It’s a process where employees gain award ownership in intervals. Again, imagine your employees are offered 300 shares of stock options with a graded vesting period of 6 years. After the first year of employment, they would receive 60 vested shares (20% of the total shares) that fully belong to them and they can exercise and sell this portion. The next year, 60 shares, and 60 shares the next year and so on.
With an immediate vesting approach, the employees receive 100% ownership of their shares at the grant date. It means they can exercise or sell the shares right away.
When an employee quits, how vested and unvested stock affects him?
If an employee wanted to quit but only a small portion of equity has vested, he/she would probably re-think. Why? Because only the vested equity can be kept by the employee while the unvested equity will usually be forfeited.
Sticking with the same example, your employees are granted 300 shares of stock options with 3-year cliff vesting. If they leave before they hit the 3-year mark, they won’t get any shares. If it’s graded vesting and only 100 shares are vested before they leave, then they can only earn these vested stock options (100 shares) but not the remaining (200 unvested shares).
Important Note: Stock options typically expire within 90 days of leaving the company, so employees could lose their vested stock options if they don’t exercise them within 90 days.
So, it's important to get your equity vesting schedule right
As just discussed, employees usually factor equity vesting into their departure decision-making. If you get it right, good employees will likely stay longer. In the global competition for talent, tech companies are tweaking their stock vesting strategies to retain them. (Skip to idea 5)
What about those who don’t perform well? This is the beauty of a vesting schedule. If you set it right, you can protect your company in case your new hires don’t perform well. (Skip to idea 4)
Let’s check more examples to help you build an ideal one:
Vesting Schedule Examples
Idea 1: 4-year cliff vesting period – It might sound attractive for the business as it can keep employees long. But realistically, a bonus in over 4 years – no matter how big a bonus – is not likely to influence behavior. Young employees, these days, switch jobs every 2.3 years.
Idea 2: Immediate vesting for certain employees – Although this approach is not common as it has no motivation for employees to stick around, you can use it to reward some key employees, e.g. those who have been working for the company for a long time.
Since the vesting schedule doesn’t necessarily need to be the same for all employees, you can customize the equity compensation plan for them.
Idea 3: 1-year cliff vesting over 4 years – This idea is similar to the first one but it enables employees to vest a portion of equity (e.g. 1000 out of 4000 shares) after the first year. So they can exercise these vested shares and/or sell them for profit. After that, vesting occurs monthly. This is a typical vesting schedule among startups (Source: Business Insider).
Of course, some employees may think “Why to put all your eggs in one basket“. So, they only stay for one year and then quit soon after hitting their cliff date for another company and doing the same thing. It inspires some companies to use another strategy – Idea 4
Idea 4: Unequal vesting over 4 years – A tech company offers its employees restricted stock units with a vesting period of 4 years. During the first year, only 5% of the stock vest. After year 2, 15% percent of the stock vest. Years three and four, however, see a big jump where 40% of the RSUs vest each year.
If employees decided to leave after year 1, they’ll leave 95% of their stock behind. If they think the company stock is valuable in the long run, this is a great way to incentivize them to stick around longer to vest a larger portion of their equity.
This approach is also good for employers because it allows you enough time to evaluate staff performance and let poorly-performing employees go before they get the bulk of their equity payouts. Imagine if they hold a large number of company shares when leaving the company and worse still you are not able to buy them back.
Idea 5: There’s no such thing as perfect but be flexible – According to Crunch Base, flexibility becomes the norm when it comes to vesting. If you find a perfect candidate, listen to what he/she wants and try to be flexible.
Although there’s no perfect vesting schedule for an equity compensation plan, being flexible can be a win-win strategy – Employees find the plan attractive and are willing to join the team, and also feel the management is understanding in dealing with staff. You, as an employer, recruit the right person to grow the company.
Amazon is considering a shift to a monthly vesting schedule (from annual vesting) for employees at Level 7 or higher. Google has shifted to more front-loaded vesting for its RSUs – from vesting 25% evenly each year to vesting 33% per year for the first two years of employment. (Source: Forbes 2022)
Other considerations for vesting
Tax for vested stock
You might or might not need to pay tax at vesting depending on the asset you hold. For example, you typically aren’t liable for tax if you own stock options and SARs. But, you may be liable for tax when your restricted stock vests. Read more about restricted stock vesting.
Double-trigger vesting for RSUs
You’re liable for tax once your RSUs vest. But what happens if you are not able to sell your vested shares due to little liquidity? Remember: Receiving vested RSUs is still a taxable event even if you can’t sell them.
But with the double-trigger vesting feature, your RSUs won’t vest until two events trigger (one may be time-based and the other one may be IPO). Once both requirements are met, the RSUs vest and can be sold to help pay the tax bill.
How we can help with stock vesting
At Global Shares, we’ve helped companies of all sizes and locations to launch their own equity compensation plans. Here, we want to give you some key factors to consider when establishing your vesting rules:
- Business goals & scale of operations (Time-based vesting builds the loyalty of the employees while milestone-based vesting focuses on performance.)
- New hire’s caliber (Be flexible to high-caliber candidates when it comes to equity compensation, as discussed in idea 5)
- Employee’s contribution to the business (Immediate vesting schedule can be considered to reward the key employees)
- Employee’s position in the organization (same as above)
- Concerns of Board (Vesting details need to be approved by the board of directors)
- Competition (Be flexible when others are moving from annual vesting to quarterly)
Once you get your plan details sorted, the next important step is equity management.
Our purpose-built platform helps to streamline the entire equity administration process, including managing different types of vesting schedules. Through the Global Shares platform, you can easily set up, track and automate all of your employee vesting schedules from one secure place, meaning less time is spent on administration and managing messy spreadsheets.
From startups to public companies, we can help you take your employee stock plan to the next level.
If you’re looking to learn more about equity compensation, check out our Equity Explained series. Whether you’re completely new to equity compensation or looking to improve your knowledge, we have a curated library of resources to help you learn all about the world of employee equity compensation.
If want to make sure your equity is in good hands, contact us for a free demo today.
FAQ about stock vesting
What does vesting mean?
To define vesting, it is a process of gaining full ownership of an asset. So, an employee doesn’t have full control over it until the vesting period has passed. Once it has passed, the asset belongs to the employee and can be exercised and/or sold.
How does vesting work?
Vesting works by setting up criteria and a schedule for becoming an owner of an asset. If the criteria or schedule isn’t met, the stock is not yet vested completely and you can’t exercise it or sell it.
What is a vesting schedule?
Through a vesting schedule, a recipient can gain asset ownership rights over time. There’re 3 approaches - cliff vesting, graded vesting, and immediate vesting. Awards of stock, stock options, and RSUs are almost always subject to a vesting schedule.
What is cliff vesting?
In cliff vesting, employees have to complete a designated time period in the organization before they can become fully vested to receive the asset. If an employee quits before the cliff date, he/she won’t receive any equity.
What happens to vested stock when you quit?
When you leave the company, you can typically keep the vested equity while the unvested equity will be forfeited (and will usually return to the company stock pool). Stock options typically expire within 90 days of leaving the company, so you could lose the vested options if you don't exercise them within 90 days.