Stock options vesting is basically earning the right to exercise a stock option. Owning a stock option doesn’t mean owning stocks outright. The stock options only give the holder the right to buy or sell the shares of the company at a set price, and on or before a fixed date. Hence, holders of stock options only own the company’s shares after exercising the stock options which can be done before or after the stocks are vested.
In this article, we will discuss the types of stock options vesting, the schedule, and how vested stock options work.
Related: Types and classes of stocks
What does vesting mean in stock options?
Vesting means earning the right to exercise stock options over a period of time. In stock options, the vesting period is the time frame that an investor or employee must wait before they are capable of fully exercising their stock options. This period may be time-based, milestone-based, or a hybrid of both.
An investor or employee doesn’t get the actual shares of stocks when granted stock options, be it ISOs (incentive stock options) or NSOs (non-qualified stock options). Rather, what they get is the right to exercise the stock options, which is to buy or sell a set number of shares at a fixed price later on in the future.
In most cases, holders will have to wait for the vesting period of the option before they can even be capable of fully exercising their stock options. While in some cases, a holder can be allowed to exercise early before the options even get vested or before the maturity date. This is, however, only permitted for American-style options.
Stock options vesting explained
The stock options vesting period as explained is the timeframe during which an employee or investor can earn the options. This means that the option holder doesn’t get to own all the options granted to him in the grant letter at once but earns them over a period of time. Companies usually set timelines known as vesting schedules that tell the holder the dates and number of years it will take to be able to earn the option.
In several cases, stock options vesting does not occur all at once. Specific portions of the option grant vest on different dates during the vesting period. When part of the option grant is vested and part remains unvested, it is said to be partly vested. In cases of partial vesting, there is a vesting schedule that shows the portion of the option that is vested over time. The schedule usually provides for equal portions to vest on periodic vesting dates, typically once per day, month, quarter, or year, over the duration of the vesting period.
The stock option grant may vest all at once or over a period of time. When vesting is granted all at once, it is known as cliff vesting but when it is granted gradually in specific increments or stages over a period of time, it is called graded vesting or retable vesting. Cliff and graded vesting can occur in uniform or non-uniform. For instance, in a case that 20% of the options vest each year for 5 years, the vesting is said to be uniform. However, it is said to be non-uniform when 20%, 30% and 50% of the options vest each year for the next three years.
For employee stock options, the essence of the vesting period is to entice the employee to keep working for the company for as long as possible. In such cases, as the number of years increases, more options are earned. For example, the vesting schedule can indicate that an employee will be able to earn 2000 options after 5 years with a company.
Companies set vesting schedules with targets that could be time-based, milestone-based or a combination of both. For instance, an option can vest due to an employee or the company hitting certain performance goals or profits.
Furthermore, some arrangements provide for accelerated vesting. This is a type of vesting where all or a major portion of the unvested shares vests all at once due to the occurrence of a specified event such as an acquisition of the company by another or a termination of employment by the company.
See also: Vesting of RSU stock and tax
Reasons for vesting stock options
- Vesting stock options can protect the company in case the employer-employee relationship goes south.
- Vesting of stock options can be used to encourage long-term commitment to the company.
- It enhances commitment to company growth
There are reasons why companies don’t just allow the option holder to earn the right to exercise their options as soon as they are granted. Generally, stock options vesting schedules are set for the following reasons:
Protecting the company in case the employer-employee relationship goes south
Stock options vesting protects the company, especially startups by serving as an insurance policy against an employee or co-founder who in the end isn’t a good fit for the company. A co-founder could walk away earlier than expected or an employee could be terminated from rendering their services to the company. In such an instance, supposing the person already has shares in the company, he/she leaves the company and still remains a partial owner of the company.
For startups, the company may not have much capital, and may not be in a strong financial position to pay market value to buy their shares back. But when the company happens to include stock options vesting in a shareholders’ agreement or an employment contract, it can help curtail such costly expenses.
The vesting period helps guarantee the buyback of shares at a price that is less than the exercise price and fair market value of the shares. Moreso, including stock options vesting, can help ensure the employee or co-fonder stays with the company for a required number of years before they can even exercise their options.
Encouraging long-term commitment to the company
Stock options vesting can signal to investors that the founders of a company are committed to growing the company. The vesting period act as bait for employees to keep working for the company for as long as possible. As the number of years increases, the employees earn more options.
Companies tend to use stock options with long vesting periods to attract and retain top-tier candidates as a better investment. This is likely to increase the value of the company as the vesting can guarantee long-term sustained involvement from these top-tier talented people.
Enhancing commitment to company growth
The contractual promise of shares or stock options encourages co-founders or employees to stay loyal to the company. It is only after the co-founders or employees have remained with the company through their vesting period that they have the right to purchase or sell their entitled number of shares. This encourages them to continue working with the company until the end of the vesting period.
More so, vesting schedules that are set with milestone-based targets could be based on the employee’s performance or the company achieving a milestone. This encourages employees to work hard individually and collectively for the growth of the company in order to be able to earn their options on time. As far as milestones can be achieved on time, they have the opportunity to quickly earn options.
Related: ISO vs NSO; which is better?
Types of stock options vesting
- Time-based vesting
- Milestone-based vesting
- Hybrid vesting
- Accelerated vesting of stock options
The vesting of stock options could be time-based, milestone-based or a combination of both (hybrid). Apart from these three types of vesting, some arrangements provide for accelerated vesting where all or a major portion of the unvested right vests all at once due to the occurrence of a specified event.
Time-based stock options vesting is when the holder earns options over a specified period of time. The majority of time based vesting schedules have a vesting cliff wherein the first portion of the option grant vests on a specific date and the remaining options gradually vest each month or quarter afterwards.
Many companies offer option grants with a one-year cliff which motivates their employees to stay for at least a year. However, if the employees leave before the one-year period, the unvested options are put back into the employee option pool.
Milestone-based stock options vesting is when the holder earns the options after a specific milestone is achieved. The milestones could be IPO, reaching a business goal, completing a project, or hitting a certain valuation. This type of vesting is not as common as time-based vesting. However, it gives an employee control compared to time-based vesting where he or she has to stay with the company for the required number of years.
For instance, a company may give a sales executive (an employee) a target of $2 million in sales to earn 1,000 options. The faster the sales executive achieves this milestone, the earlier his 1,000 stock options are vested (earned). This is a better condition that the sales executive has control over, compared to time-based vesting which would require him to work for years to earn the same options.
This is a combination of time-based and milestone vesting. Hybrid vesting will require the holder to simultaneously achieve one or more milestones and work at the company for a certain period of time in order to be able to exercise their stock options.
Accelerated vesting of stock options
Due to certain occurrences, the vesting schedule can be disregarded or sped up for an employee to gain access to the stock options or restricted company stock issued to him/her as an incentive. This kind of vesting is called accelerated vesting of stock options which usually occurs when the company is sold or there is a change of control.
The rate of vesting in accelerated vesting is typically faster than the initial or standard vesting schedule. Hence, the employee receives the benefit from the stock or stock options much sooner than the initial vesting schedule.
There are tax consequences for changes in vesting for both the company and the employee. Therefore, if a company chooses to take on accelerated vesting, then it may expense the costs associated with the stock options sooner.
Accelerated vesting provisions are generally divided into two categories, namely single-trigger vesting and double-trigger vesting.
Single-trigger vesting allows a certain percentage of any unvested stock granted to the employee to immediately vest, consequent to the occurrence of a specific condition like a change of company control. The percentage of unvested stock allowed to vest is normally based on a formula that takes into account the time period and number of unvested shares.
Double-trigger vesting allows for immediate vesting due to either the termination of the employee’s appointment without justification or cause by the purchasers of the company or the resignation of the employee for a good reason based on the demands or requirements of the purchasers of the company. In the event that a company is acquired, the double-trigger vesting clause protects the employee from unfair treatment.
Read about: Stock options vs equity
Stock options vesting schedule
- Four-year vesting period with a one-year cliff
- Four-year vesting period with no cliff
- Two-year period with a one-year cliff
When signing a stock option agreement form, one of the factors to look out for is the vesting schedule. It is one of the conditions to exercise in the terms of a stock option agreement. The stock options vesting schedule shows when you’ll earn your options or shares which is usually detailed in your option grant. When you’re awarded stock options, the vesting schedule is what determines when you’ll actually own them and when you will be able to exercise them.
Vesting schedules are basically used by companies to encourage their employees to build the company and earn their options by staying with the company. If not, employees would just exercise their options as soon as they’re granted and move to another company.
The majority of companies follow a four-year vesting schedule with a one-year cliff, while some follow a four-year vesting period with no cliff. These are not the only types of vesting schedules out there. Others aren’t very common but are still used such as the two-year period with a one-year cliff or a negotiated vesting schedule. There are some instances, where executives with more leverage negotiate their options to vest under a different schedule that works better for them, though you barely come across such schedules.
We will be looking at the two common stock options vesting schedules:
Four-year vesting period with a one-year cliff
Cliff vesting of stock options is a type of vesting schedule where you don’t get any of your options until a certain date. On this specific date you get a chunk of your options all at once (the cliff) and then after, you receive a portion of the remaining options when all your options have vested.
A four-year vesting period with a one-year cliff is the most common cliff vesting schedule. In this schedule, you get nothing for the first year. Then, after the first year, you immediately own 25% of your options and can start exercising them. Then every month after that, you get 1/48th of your options until they’ve all vested after four years. That is, after the 25% of options earned after the first year cliff, you later earn 100% of your options after your fourth year. At that point, the options are 100% yours and you can exercise them.
That is under a standard 4-year vesting period with a 1-year cliff, 1/4 of your shares vest after one year. After the cliff, 1/48 of the original grant (or 1/36 of the remaining granted shares) vest each month until the four-year vesting period is over. Making you fully vested after four years.
Four-year vesting period with no cliff
Cliff vesting of stock options may be the most common, but it’s not the only vesting schedule out there. The four-year vesting period with no cliff is the second common vesting schedule for stock options. This schedule happens sometimes when a company gives an employee a bonus options grant also known as a refresh grant.
In this vesting schedule, because the company and the employee have an already established good relationship, a cliff is not attached to the bonus. Therefore, the options or shares start to vest immediately over the next four years.
Related: Diluted shares formula and examples
Example of stock options vesting
Let’s look at an example to illustrate the vesting of stock options.
Miss Mary is hired at a new startup on Jan 1, 2020, and the company offers her employee stock options as part of her compensation package. Here are the details of the option grant:
Grant date: 1/1/2020
Options granted: 9,000
Vesting schedule: Time-based; monthly for 4 years with a 1-year cliff.
This means Miss Mary is offered 9,000 option shares and the vesting schedule is for 4 years with a one-year cliff. That is, she has to continue working with the company for one year to be able to earn any shares at all and after one year the remaining shares vest monthly at 1/36. Therefore, if she leaves before this, she will have unvested shares.
Let’s say, one year after Mary’s hire date, on January 1, 2021, she reached the vesting cliff and 1/4 of the shares (2250 shares) were vested. At that time, Mary can exercise (though she isn’t obligated to) the 2250 shares.
Based on the company’s stock options vesting schedule for Mary, it is calculated that after 1 year, 2250 shares are vested. Then, every month, 1/36 of the remaining 6750 shares are vested. That is an additional 187.5 shares are vested every month as shown in the table below:
|January 1, 2021 (after the first year)||2250||(1/4 of 9,000)= 2,250|
|February 1, 2021||187.5||2437.5|
|March 1, 2021||187.5||2625|
|April 1, 2021||187.5||2812.5|
|May 1, 2021||187.5||3000|
|June 1, 2021||187.5||3187.5|
|July 1, 2021||187.5||3375|
|August 1, 2021||187.5||3562.5|
|September 1, 2021||187.5||3750|
|October 1, 2021||187.5||3937.5|
|November 1, 2021||187.5||4125|
|December 1, 2021||187.5||4312.5|
|January 1, 2022||187.5||4500|
Over the next three years, an additional 187.5 shares vest every month. By January 1, 2024, Mary’s options will be completely vested, and she can exercise all 9000 of the shares in the option grant if she wants. The table below shows the stock options vesting over the years:
|1/1/2021 (after one-year cliff)||2,250||(1/4 of 9,000)= 2,250|
Nevertheless, if Mary happens to leave the company before January 1, 2024, all the unvested shares will be returned to the company’s option pool.
How do vested stock options work?
After the vesting period what next? When stock options vests, it means that the options are available for you to exercise. This means you have actually earned the right to buy or sell the shares of the company at the exercise price of the option. After hitting the vesting cliff, one can be able to exercise the vested stock options whenever as long as the person remains employed. What to do with stock options when they vest is to simply exercise them immediately or wait a little while if you wish.
Now, using the preceding example, let’s assume Miss Mary stayed at the company all through the four years and has earned the vested 9,000 shares. She can choose to exercise the option by buying the shares at the exercise price.
If she was offered 9,000 option shares at an exercise price of $1 per share as of Jan 1, 2020, and by 2024, the company shares are trading at a price of $10 per share. She can choose to exercise her stock options. This means she will purchase the 9,000 shares of the company at the exercise price of $1 per share. This can be a big win for her because she will buy the 9,000 shares that are worth $90,000 for a total of just $9,000. Therefore, if Mary decides to sell her shares, she will earn an income sale of $81,000. The income sale is the difference between the fair market value of the shares ($90,000) and the exercise price ($9,000).
See also: Differences between stocks and shares
Should you exercise stock options as soon as they vest?
Once options are vested, the holder can exercise as many or as few options as he/she wants with no restrictions. However, one can choose to not exercise their options as soon as they vest. There can be some legitimate reasons to wait a bit longer before exercising.
For instance, the option holder may be very optimistic that the market price of the company stock will continue to increase over time. In such instances, holding onto the options a while longer may be reasonable. However, the drawback of this is that you can not be 100% sure that the stock’s price will continue to go up. Also, if your options pass their expiration date, they will expire with no value.
Are vested stock options taxable?
Taxes on vested stock options depends on the kind of stock option you have, whether it is an ISO or NSO; and how long you hold those options before selling them. For non-qualified stock options, you pay ordinary income taxes when you exercise the options, and capital gains taxes when you sell the shares. Whereas, for incentive stock options, you only pay taxes when you sell the shares, either ordinary income or capital gains, depending on how long you held the shares.