You recently got a new job and see that you have been given equity as part of your compensation package. But, what does that mean exactly?
When your company gives you equity, you are getting partial ownership of the company. However, usually there is a catch – your stocks have to vest first. That means you need to earn the investments over time. This process typically applies to stock options and employee-match contributions to your 401(k) to encourage you to stay at the company longer and/or perform well. If you are unsure how vesting works, we’ll explain everything you need to know in simple terms.
- Many companies offer equity to their employees as part of their compensation package to motivate them to perform well and boost employee retention.
- There are three common types of vesting schedules – time-based vesting, milestone-based vesting, and a hybrid of both.
- There are several disadvantages of stock vesting for employees to note.
Many companies, particularly startups, will offer their employees equity in their compensation packages. Equity comes in many different forms – for example, the equity you receive as an employee may differ from the equity that investors receive or founders’ equity.
When your company gives you equity in your offer letter, you are signing an agreement that entitles you to a certain amount of equity when specific conditions get met in the future. When you fulfill these conditions, such as working at the company for a certain amount of time or hitting specific milestones, then your equity is vested.
Think of vesting as getting the right to earn some benefits at a future time, such as stock options or employer contributions to your 401(k). A key characteristic of most employee equity is that it vests gradually over time.
There are two main types of equity – stock options and restricted stock.
- Employee Stock Options (ESOs): If you get granted ESOs, you earn the right to purchase the shares of stock at a preset price when the shares become fully vested.
- Restricted Stock Units (RSUs): If you get granted RSUs, you earn ownership of the stocks when they become fully vested, meaning you do not need to pay for them.
When we talk about vesting stock, that means you have not earned the ESOs or RSUs yet. Until they get vested, you do not have the right to purchase or own them.
Vesting schedules outline the process of how your stocks vest and what you need to do to earn them. Every company will have different schedules set up for their employees to award them over time.
Types of Vesting Schedules
The three common types of vesting schedules are:
Time-based vesting is one of the most common types of stock vesting. Under this method, employees earn their share of stock options or RSUs over a certain amount of time, typically based on a specified period and a cliff. The cliff serves as the minimum amount of time you need to stay at the company for your equity to start vesting. The remaining options will vest on a monthly or quarterly basis, depending on the terms of the vesting schedule.
Most of the time, companies will not let you exercise your equity until you have been at the company for at least one year. That is your vesting cliff, which is the point at which you can gradually start exercising your equity. If you leave the company before your equity is fully vested and the post-termination exercise period elapses, the unvested options get put back into the option pool.
The standard vesting schedule is a four-year time-based vesting schedule with a one-year cliff. Under this schedule, 1/4 of your shares will vest after one year. Then, 1/36 of your remaining shares will vest each month until the four years is over. At the end of four years, your equity will be fully vested.
Let’s say you start working at Finance Futurists on January 1, 2022, and are granted 2,500 option shares with the vesting schedule above. If you end up staying at the company for one year (until January 1, 2023), then 625 shares would have been vested. Every month after the first year, an additional ~52 shares get vested per month. After four years, your stock options would fully vest.
The purpose of the cliff is to prevent you from leaving right after you accept the offer. Without the cliff, you could sign the job offer, work at the company for a few weeks or months, buy equity, and then quit with your gains.
Keep in mind that each grant option will have its own vesting schedule. That means, if you received a grant in 2021 with a four-year vesting schedule and another one in 2023 with a four-year vesting schedule, your options will not fully vest until 2027. Another thing to remember is the length of your vesting schedule, which details how often and how long it will take for your equity to vest.
Milestone-based vesting is a type of vesting schedule tied to value-creating tasks rather than time. Examples include:
- Pre-determined key performance metrics (KPIs) you need to hit to vest a % of your equity
- Specific projects you deliver, such as selling a certain number of units or completing the development of a software feature
- Business goals reached, such as the company hitting a certain valuation
From the company’s perspective, this method rewards good performance rather than loyalty. But, the downside is that these performance metrics can be hard to measure or take a long time to materialize, which can lead to disinterest or lost hope. That is why many employers prefer time-based vesting over milestone-based vesting.
Hybrid vesting combines time-based and milestone-based vesting. Under this method, you need to stay at the company for a pre-defined amount of time and achieve set milestones to be allowed to exercise your equity. For example, you may need to stay at the company for at least one year and meet specific KPIs to be allowed to exercise the first 1/4 of your equity.
Stock Vesting Example
To help you better understand how stock vesting works, let’s go over a real-life example and outline the different scenarios that can happen.
Vesting Terms of the Employee Stock Options
Finance Futurists hired John on January 1, 2021. As part of his offer letter, Finance Futurists gave John the following option grant:
- Grant Date: January 1, 2021
- Number of Shares: 20,000
- Vesting Schedule: Four-year vesting schedule with a one-year cliff, 1/36 of the remaining shares vest monthly afterward
After one year from John’s hire date, on January 1, 2022, he reaches his cliff and 1/4 of his shares (5,000 shares) vest. He can now exercise these 5,000 shares, though he is not obligated to do so.
Over the next three years, an additional ~416.67 shares will vest every month. By January 1, 2025, all of John’s equity will be completely vested, and he can exercise all 20,000 shares in his option grant. But if John leaves the company before this date, his unvested shares will get returned to the company’s pool option.
Vesting Stock Scenarios
John leaves after six months: In this scenario, because John left before the one-year cliff, zero shares get vested. Because he did not stay for at least one year, he is not entitled to any equity.
John leaves after one year: In this scenario, John earns 5,000 shares. According to the vesting schedule, after one year, 25% of the equity gets vested.
John leaves after 24 months: In this scenario, John earns 10,000 shares. That is because he earned 5,000 shares after year one, with 15,000 shares remaining. Because he stayed for an additional 12 months out of the remaining 36 months, he earned 12/36 of the remaining shares or 5,000 shares. So, the total vested is 5,000 (vesting cliff) + 5,000 (12 additional months) = 10,000 shares.
John stays for at least four years: In this scenario, John’s equity would have fully vested, so he earned all 10,000 shares.
As stated earlier, when you leave the company before your equity is fully vested, your equity will stop vesting immediately. You are only entitled to the amount vested as of that date. Additionally, you will only have a set timeframe to receive your equity, known as a post-termination exercise (PTE) period. Some companies set this period to three months, though others may have more generous PTE periods.
If you decide to leave your company and have not yet exercised your equity, your company will typically give you a period of time to exercise your vested equity. This “exercise window” typically lasts 90 days, though you may need to check your grant agreement to confirm. If you choose not to exercise for whatever reason, that equity gets automatically reclaimed by your company.
Stock Expiration Date
The stock expiration date marks the end of your exercise window. Any vested equity that you did not exercise will get returned to the company.
Problems with Stock Vesting
Lack of Transparency or Communication
Sometimes employees do not fully understand what they own or how to claim their equity. In the past, when I have received offer letters with equity, I had no idea what any of it meant because I didn’t have a fully understanding of the exercise (strike) price, fair market valuation, vesting requirements, type of equity, etc.
Depending on the types of shares vested and when you choose to buy and sell your equity, you may face different tax consequences.
Length of the Vesting Schedule
Recently hired employees will not receive any benefits if there is a vesting cliff or if they are fired before the schedule gets completed.
Everyone’s risk profile is different. Some people prefer liquidity over equity and thus would prefer a higher base salary over equity. Others prefer going all in on equity and are willing to take a pay cut to bet on the equity having a higher value in the future. This is a personal choice based on people’s unique circumstances and not necessarily a reflection on their thoughts on the company. Given my age, financial circumstances, and medium-term goals, I tend to favor liquidity at this time.
The Bottom Line
Stock vesting is beneficial for both companies and employees. From a business standpoint, stock vesting incentivizes employees to perform better and stay at the company longer. From an employee standpoint, you get to reap the benefits of your hard work and loyalty.