When your provider provides you with equity as part of a compensation package, they are essentially offering you partial ownership of their company.
However, this stock will normally have to vest first, which means that you usually will need to work for the company for a specific period of time if you wish to become a partial owner.
Thus, vesting describes the process of earning an asset. These assets can take the form of stock options known as vested stocks.
Companies will often use vesting in order to encourage you to remain at the company for a longer period of time.
Stock Vesting In Detail
Vesting is otherwise known as “exercising your options” by earning the right to purchase shares in a company over a period of time.
Unless your company allows to to exercise this option earlier, you will usually only be able to exercise stock options that have been vested over a specific time period.
ISOs And NSOs
Whenever you have been granted stock options, like incentive stock options (ISOs) or non-qualified stock options (NSOs), you are not receiving literal shares of stock immediately.
Instead, you are gaining the right to exercise any stock options which translates as the right to purchase a specific amount of shares at a fixed price at a later date.
What Is Vesting RSUs?
If your company allows you to purchase restricted stock units of RSUs, it is thereby giving you actual shares of its stock, which you will be able to sell at a later date.
You may need to remain at the company for a specific amount of time to sell these, and sometimes you need to hit a specified milestone in order to be able to vest RSUs.
However, unlike stock options, you do not need any permission in order to own them. Instead, you simply need to wait for them to be vested.
What Is A Vesting Schedule?
A vesting schedule highlights when you will have earned your options or shares. It is usually detailed within your option grant that has been specified by your employer.
The most common types of vesting schedules are as follows: time-based, milestone-based, and a hybrid of the previous two.
Time-based stock vesting occurs whenever you have earned options or shares over a specific period of time.
The vast majority of time-based vesting schedules will have a vesting cliff.
Cliff vesting is defined as when the first portion of your option grants decides to vest on a specified date while the remaining options will gradually vest month by month or each quarter thereafter.
Many companies will offer these option grants alongside a one-year cliff in order to motivate their employees to remain at the company for at least another year.
If you decide to leave prior to the one-year mark, then any unvested options will be placed back into the option pool for other employees to utilize.
A traditional four-year vesting schedule with a one-year cliff will result in 1/4 of your shares vesting after one year.
After the one year cliff, 1/36 of your leftover granted shares will vest month-by-month thereafter, until the four-year vesting period has concluded. After a period of four years, your shares are fully vested.
You should note that every option grant will have its own vesting schedule. Thus, vesting is not always based on your tenure.
For instance, if you have received a grant alongside a four-year vesting schedule and have then received a second grant along with a four-year vesting schedule from your company, you will not have fully vested all options from both of your grants until eight years have passed.
What Is Milestone-Based Vesting?
Milestone vesting occurs when you have earned your shares or options after a specified milestone. Asides from IPO, milestones could be defined as completing a project or completing a specific valuation.
This form of vesting is not typically as common as time-based vesting.
Hybrid vesting combines time-based and milestone vesting.
This specific model will require you to work at the company for a specific amount of time while also hitting one or numerous milestones in order to receive your shares or options.
What Is The Purpose Of Companies Offering Vested Stock Options?
Since the majority of startup companies or smaller companies will not have enough revenue or cash flow to begin with, they usually offer vested stock options as opposed to cash bonuses.
Cash can then be used for other purposes such as employment or paying off any existing loans.
Employee Loyalty And Lower Turnover
Retaining employees is a key part of running a successful business.
Whenever an employee is truly happy and satisfied with his or her employment, it is highly likely that they will continue to work for their company for many years to come.
This makes them a valued asset for the company. Therefore, in order to avoid losing any employees, most companies will offer vested stock options as incentive.
Companies that utilize vested stock to attract or keep their employees will do so by promising a specified number of shares within a certain time period.
Thus, vested stock vesting is used as a means of deferred compensation.
Vested stock has also been used by companies in order to ensure that their best employees remain at the company for a long period of time.
This method is known as vesting stock because the stock vests slowly over a period of time.
A typical vesting period at most companies ranges from three to five years.
The main idea behind vesting stock is that employees are more motivated to remain with their company for a longer period of time.
They will then be able to receive the benefit of obtaining stock options as a well-balanced incentive for their dedication.
To conclude, vested stock (see also ‘What Are Advisory Shares?‘) is offered to employees as an incentive to remain at their company for a longer period of time.
Stock becomes vested after a certain number of years, from which point the employee will be able to utilize the benefits of having vested stock.