What is Stock Vesting and How Does it Work?

Casey Fenton

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September 2, 2023

What is Stock Vesting and How Does It Work?

As a startup founder, you may have heard the term "stock vesting" before but aren't quite sure what it means. In this blog post, we will explain what is stock vesting and how it works so that you can make an informed decision about whether or not to offer it to your workers as a form of employee compensation. By understanding stock vesting, you can be confident that everyone involved in your company is on the same page about employee ownership, goal alignment, and future expectations. So, let's get started!

What is Stock Vesting?

Stock vesting is a process by which an employee or other individual earns the right to purchase or receive shares of company stock. Typically, vesting occurs over time, and conditions may be attached to the vesting process, such as continued employment or achievement of certain performance milestones. 

Vesting can be an essential part of employee compensation planning and an HR strategy for employee retention, as it gives employees an incentive to remain with a company for the long term and can help to align their interests with those of shareholders. Stock vesting also has tax implications, as the value of the vested stock is typically treated as income in the year it is received, and thus imposes an income tax.

What are the Benefits of Vesting?

Vesting is an integral part of employee compensation plans. When an employee vests, they are essentially gaining ownership of their benefits. This has several advantages for both the employer and the employee. 

For the employer, vesting helps to ensure that every employee joins in committing to the company, and is less likely to leave before the business achieves its peak. It also allows the employer to attract and retain top talent, thus preventing situations where the employee leaves prematurely. 

Meanwhile, for the employee, vesting stock provides financial security and peace of mind. It also gives them the incentive to stay with the company for a long term commitment and build their career. Ultimately, vesting benefits both parties and helps create a more stable and productive workforce.

There are two types of employee compensation plans that are based on equity ownership: restricted stock and stock options.

RSU Vesting

Restricted stock is called "restricted" because it comes with certain restrictions or conditions that limit the recipient's full ownership rights until those restrictions are met. But don’t be put off by these since these restrictions only refer to the vesting process and requirements, which determine when the recipient can fully own and transfer the shares.

By vesting over time, employees are incentivized to stay with the company and help it succeed. This can be especially important for startup founders, which often have a lot of turnover in the early years. 

Stock Vesting

For startup companies, stock vesting protects the company by ensuring that employees are committed to the long-term success of the business, and it also motivates employees by giving them a stake in the company's success, a.k.a. equity ownership.

There are several benefits of stock vesting for both employees and employers. Employees are incentivized to stay with the company for at least a few years until their stock vests fully. It also gives them a sense of ownership in the company as the employee completes his performance milestones towards the vesting of company stock.

For employers, stock vesting helps to retain top talent and keep them aligned with the company's long-term goals. It can also attract new talent, as potential employees often view a company's vesting schedule as an indicator of its commitment to its employees' future success.

Why Do Companies Need Vesting?

Vesting is an important tool for companies to retain key employees. When employees vest, they have earned the right to keep their stock options or other company-provided incentives and even retirement benefits.

This vesting period may take at least a year or over many years, and companies can leverage this to curb incidences where a top employee leaves before at a critical stage of the business’s growth.

There are several reasons why vesting is beneficial for companies when offering equity-based compensation packages to their employees.

First, vesting can help ensure that competitor firms do not poach critical employees. In any cutthroat industry, this could mean that the employee leaves their current company due to the competitor’s attempts at pirating top talents.  

Secondly, vesting can motivate employees to perform high since they know they will be rewarded for meeting vesting requirements. This is particularly important in an equity-based compensation package that ties in milestone based vesting relevant to performance metrics.

Finally, vesting can help build loyalty among a company's workforce, contributing to a more positive work environment.  It is a crucial tool company uses to retain key employees and motivate them to perform at a high level with milestone vesting and vesting periods that require them to stay longer for their own career growth and the company’s success.

What Is A Vesting Schedule

A vesting schedule is a timetable that outlines when employees will vest or become fully entitled to employer contributions to their retirement plans. There are different vesting schedules, but the most common is a graded vesting schedule, which allows employees to have gradual vesting over time. 

How Does a Vesting Schedule Protect the Company?

Vesting schedules are often put in place by companies to protect themselves from cases where a valued employee leaves the company before a certain amount of time has passed. For example, if an employee has been with a company for two years but decides to quit, a vesting schedule would ensure that the employee does not walk away with all the benefits they would have accrued for those two years. 

Instead, by offering them equity compensation that requires reasonable vesting periods, the employee would only be entitled to a portion of those benefits. Vesting schedules can also protect companies from employees who may be fired or laid off before their vesting period is up or when the stocks can be fully vested. In such cases, the employee would not be able to collect any of the benefits they had not yet vested in. 

While vesting schedules may seem unfair to employees, they are simply implemented to protect the company's interests and help workers align their goals with that of the business. The waiting period prescribed until the shares vest also signifies the desire of the company to hone and nurture talent for the employees’ own career growth.

Types of Vesting

1.  Immediate Vesting

With immediate vesting, employees are 100% vested in their employer-sponsored benefits immediately. This differs from a vesting schedule, where employees become more vested over time. For example, an employee may be 25% vested after at least a year on the job, 50% vested after two years, and so on. 

While immediate vesting is more generous to employees, it can also be more expensive for employers. As a result, it is not uncommon for a chief executive officer and stakeholders to opt for a vesting schedule instead. 

However, for specific industries such as tech startups,  immediate vesting is becoming more common than those that are vested gradually. This is because an industry like a software company often puts high regard on attracting and retaining talent 

2.  Cliff vesting

Cliff vesting is a vesting schedule requiring an employee to stay with a company for a certain time before fully vested in their benefits. For example, if an employee has a 401k plan with a cliff vesting schedule, they may need to stay with the company for five years before they are fully vested and can access the funds in their account. 

Employees fully vested in their benefits are more likely to stay with a company long-term, while employers can use cliff vesting to retain talent and keep turnover low.

Cliff Vesting Examples

One Year Cliff

The most common vesting period in many equity-based compensation plans is the one year cliff, which means that the employee must stay with the company for 1 year before they are eligible to receive any benefits. After the 1 year mark, the employee becomes fully vested and is eligible to receive their complete equity compensation plan. 

Three-Year Cliff

Three-year cliff vesting schedule requires an employee to work for a company for 3 years before they are eligible for any stock awards or other benefits. This vesting schedule is often used in connection with stock options and other equity compensation. 

In the same example as above, the three-year cliff ensures that employees are vested for a certain period before they can receive any benefits, which helps protect the company from early departures. 

However, in many cases, the three-year vesting cliff will also include a one-year "vesting period" after the three years have elapsed, thereby creating a four year vesting schedule in total. Here, employees must remain with the company for 4 years before fully vested. While a three-year cliff period can create some challenges for employees, it can also benefit them, especially when the chief executive officer prefers milestone vesting based on key performance indicators (KPIs), which can serve as a motivation to excel in their careers. 

3.  Graded Vesting

A graded vesting is a typical vesting schedule that gradually increases the number of unvested shares or units an employee can receive. The most common form of graded vesting is annual, typically occurring over three to five years. 

Each year, the employee becomes eligible for an additional portion of the total number of vested shares or units granted. For example, if an employee is granted 1,000 units with a three-year graded vesting schedule, they would be eligible to receive 300 units after the first year, 600 units after the second year, and 300 units after the third year. 

Graded vesting schedules are often used in employer-sponsored retirement plans, such as 401(k)s and 403(b)s. However, aside from equity-based pension plans, they can also be used in other employee benefits packages, such as employee stock options plans.

4.  Accelerated Vesting

In accelerated vesting, the company allows the employee to vest their stock options or restricted stock units (RSUs) earlier than the expected date. Accelerated vesting usually happens when there's a change in control at the company, such as a merger, acquisition, or IPO, which triggers the employee stock to vest even without following the time based vesting schedule prescribed in the equity-based compensation plan.

In most cases, the accelerated vesting is triggered by job loss. Here, the accelerated vesting benefits the employee because it allows them to keep their equity compensation even if they're no longer with the company. 

Furthermore, in the same example, it also benefits the company because it helps retain talent and motivate key employees. Still, it must be noted that accelerated vesting can also be a liability for the company, although good equity management can efficiently address such concerns. 

Vesting Schedules for Stock Options

Vesting schedules for stock options are set up in order to provide an incentive for employees to remain with a company for a certain period. The typical vesting schedule is four years, with a one-year cliff. 

Vesting Schedules for Restricted Stock Units

Vesting schedules for restricted stock units (RSUs) are usually either cliff vesting or graded vesting. Under the cliff vesting, the entire RSU award vests at once on a specified date, unlike stock options that mostly rely on gradual vesting. 

On the other hand, with graded vesting, the RSU award vests in installments over time. The main difference between the two types of vesting schedules is when an employee earns the right to exercise their RSUs and purchases them at their exercise price. 

Vesting schedules for RSUs should be designed to align with the company's business goals and objectives. For example, if a company is trying to promote long-term employee retention, a graded vesting schedule may be more appropriate than a cliff vesting schedule.

Alternatively, vesting schedules can also be used to incentivize specific behaviors or performance outcomes, a.k.a. milestone vesting. For example, a company may want to encourage employees to grow with the company for at least three years, so they may require that RSUs be vested in installments over that time. 

The good thing about vesting schedules is that they can be customized to meet the needs of both the company and the employee. Hence, it’s essential to get expert advice in choosing the vesting schedule that is mutually beneficial for all parties.

What is a Vesting Agreement

A vesting agreement is a contract between an employer and an employee that outlines the conditions under which the employee will vest or become entitled to company stock or other benefits. This should include a vesting schedule outlining how and when the shares vest. It should also specify the vesting price at which shares may be sold or transferred.

In addition, the agreement should identify any restrictions on the sale or transfer of shares and set out the procedure for vesting in case of a change in control of the company. By including these essential elements, a vesting agreement can help to ensure that all parties involved in a shareholder arrangement are protected.

If you are considering entering a vesting agreement, it is essential to consult with an experienced attorney who can help you understand your options and ensure that your agreement is properly executed. 

Alternatively, you can look into Upstock’s straightforward and no-nonsense compensation solutions that highlight the all-encompassing benefits your company can enjoy while similarly improving talent acquisition and retention. Should you need further information, our lines are open to answer any inquiries that will hopefully convince you to try our offerings.

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ABOUT THE AUTHOR

Casey Fenton

Founder, Upstock & Couchsurfing, AI and Equity Innovator

Casey Fenton, the founder of Upstock & Couchsurfing and an AI and equity innovator, has revolutionized how we perceive and implement equity in the workplace. His foresight in creating platforms that not only connect people but also align their interests towards communal and corporate prosperity has established him as a pivotal figure in technology and community building. Casey speaks worldwide on topics including ownership mindset, worker equity, With Upstock and Couchsurfing, he has demonstrated an unparalleled expertise in harnessing technology for the betterment of community interaction and organizational benefits.

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