What Is Stock Vesting and What Does It Mean to Be Vested?
Companies that grant equity as part of their compensation packages tend to attach certain stipulations to their employees’ equity awards. Generally speaking, this is to ensure that employees only receive full ownership of their equity after they’ve demonstrated a sustained commitment to the company. This whole notion of earning the right to own equity is called vesting.
In this guide, we’ll aim to give you a clear and simple understanding of vesting—and how stock vesting works in particular. Why should I care, you ask? Because understanding how and when your equity vests can help you make better, more informed decisions about the future of your employment. It can also help you calculate how much the equity you own is actually worth at any given time. Which, in our humble opinion, is a good thing to know.
While vesting is a legal term that can apply to a number of different types of equity and benefits, we’ll focus our attention on stocks first and foremost. But don’t worry—if you have questions about vesting as it relates to retirement plans or other employer benefits, we’ll spend a bit of time on those topics, too.
- What is stock vesting?
- What types of awards and benefits does vesting apply to?
- What is a vesting schedule?
- What happens to unvested awards if the employee leaves?
- Final thoughts: Why vesting should matter to you
What is stock vesting?
To understand stock vesting and why it’s so popular among companies that offer equity-based compensation, it helps to think of a carrot and a stick.
Tying a carrot to a stick and holding it a tantalizing distance in front of a horse’s field of vision can compel that horse to run faster (or so we’re told). Companies use stock vesting in a similar, though perhaps less crude, manner. Rather than grant ownership over the entirety of an award upfront, they may attach vesting requirements satisfied by a certain time period (i.e. time spent as an active employee) or set of performance milestones. The idea is that having an award to look forward to can lead to better employee retention and performance.
So, at least as it relates to equity awards and bonuses, vesting is really just a way for companies to ensure—or at least encourage—a sustained commitment from their employees.
This is not indicative of anything devious on their part. In fact, an equity grant should clearly describe the exact vesting requirements that must be satisfied in order for equity ownership to pass over to the employee. So, as an employee of a company, you should know right off the bat what you’ll need to do to receive a fully vested equity award.
What types of awards and benefits does vesting apply to?
“Vesting” is a pretty general term that can apply to a number of employee benefits and awards. To give you a sense of where you may need to look out for information about vesting, here are a few places where it commonly applies.
- Employee stock options: An employee stock option is a type of compensation that gives an employee the right to buy a number of shares of company stock at a specific price. Most option plans require stock options to vest before the employee exercises them.
- Restricted stock units: Restricted stock units, or RSUs, are another type of equity compensation. Like stock options, RSUs tend to be earned on a vesting schedule. Unlike stock options, they don’t have a strike price. Instead, they convert into common stock when they vest.
- Restricted stock awards: A restricted stock award, or RSA, is a grant of company stock that’s restricted in certain ways. An employee who accepts the grant technically owns the stock from the grant date—but their rights to that ownership may be subject to certain vesting conditions. For example: If the employee leaves or is terminated before their shares are fully vested, the company may have the right to repurchase any unvested shares.
- Qualified retirement plans: Some company retirement plans include employer-matching contributions. This means that the employer agrees to “match” a certain percentage of the money an employee puts into, for example, a qualified 401(k) account. Matching employer contributions are commonly subject to a vesting schedule, whereby the employer puts in a greater percentage if certain vesting requirements are met.
- Pension plans: Pension plans commit an employer to regularly contribute payments to an employee after they retire. Pension plans can be costly for the employer, so it makes sense that they are often (read: nearly always) subject to a vesting schedule of some kind.
What is a vesting schedule?
An equity grant that’s subject to vesting should come with a vesting schedule. This vesting schedule tells you what needs to occur before you earn the right to exercise your options (in the case of stock options) or own your common stock (in the case of RSUs).
A vesting schedule is typically based on a specific period of time from the grant date. This is not always the case, as vesting may also account for non-time-based milestones, such as job performance or company performance. But most commonly, a vesting schedule will outline a certain number of years of service that have to pass before the employee is considered fully vested.
Though vesting schedules vary between companies, a time-based vesting schedule of four years is perhaps the most common. Vesting periods of up to five years or six years are possible, and in some rare cases, immediate vesting may apply.
And just because vesting takes place over a certain period of time doesn’t mean it has to take place in a gradual, linear fashion. Let’s take a look at two types of vesting schedules to illustrate this point.
What is graded vesting?
With a graded vesting schedule, the employee gradually gains ownership of their options or shares over time. This is a pretty common practice that essentially spreads out the entirety of the award over the vesting period.
Here’s an example of a graded vesting schedule for a grant of 4,000 RSUs that fully vest over a period of four years:
- After the first year: 1,000 RSUs vested (25% of total award vested)
- After the second year: 1,000 RSUs vested (50% of total award vested)
- After the third year: 1,000 RSUs vested (75% of total award vested)
- After the fourth year: 1,000 RSUs vested (100% of total award vested)
What is cliff vesting?
As opposed to graded vesting, a cliff vesting schedule means that the entirety of an award is granted only after the employee has stayed with the company for a certain period of time.
To illustrate this point, let’s use the same example as above—only this time, we’ll assume a vesting cliff after the fourth year:
- After the first year: 0 RSUs vested (0% of total award vested)
- After the second year: 0 RSUs vested (0% of total award vested)
- After the third year: 0 RSUs vested (0% of total award vested)
- After the fourth year: 4,000 RSUs vested (100% of total award vested)
What is a one-year vesting cliff?
To make matters just a little more confusing, many companies use a sort of hybrid of cliff and gradual vesting. In one particularly common model, equity vesting schedules are subject to a one-year vesting cliff.
A one-year cliff means that the employee’s options or stock awards start vesting only after they have stayed with the company for a full 12 months. After that, the remainder of the award vests in a graded way, i.e. on a monthly or quarterly basis.
What happens to unvested awards if the employee leaves?
In most cases, when an employee leaves prior to being fully vested, that employee will surrender or forfeit all of their unvested shares or options. This typically also applies to any other employer benefits that haven’t fully vested, such as matching contributions in a qualified retirement plan.
Remember: one of the main points of vesting is to give employees an incentive to stick around and build something great. If a ton of employees leave within 12 months and take a ton of vested options with them, then the option pool shrinks for future employees and those who chose to stick around. Many companies put a lot of thought into how they structure vesting in order to avoid this eventuality.
Does this mean an employee should stick it out in a toxic situation just to fulfill the vesting requirements on their equity award? Probably not. But it is a major factor to account for when considering a change of scenery.
Final thoughts: Why vesting should matter to you
Whether you’re a startup founder, a human resources professional, or an employee just trying to make sense of the wild world of equity, we hope this guide has given you a better understanding of vesting and why it matters.
As we noted above, companies put a lot of thought into vesting because it can have a significant impact on everything from equity dilution to employee retention. But it’s also important to remember that equity decisions are personal, just as much as they affect a company’s bottom line. If you have any questions about a current equity award’s vesting schedule, we encourage you to reach out to a company representative as well as a trusted financial advisor to discuss your options.
And if you want to chat about equity from a founder’s point of view? Pulley has you covered. Schedule a call with one of our experts today and learn how Pulley can help you attract better talent and stay compliant with our top-rated cap table solution.