Retirement

Vesting Stock: How It Works With Easy Example (2022)

What Is Vesting Stock? In employee compensation, vesting stock refers to shares held by an employee that were granted either through employee stock options 
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What Is Vesting Stock?

In employee compensation, vesting stock refers to shares held by an employee that were granted either through employee stock options (ESOs) or restricted stock units (RSUs), that is not yet earned by the employee. Vesting is a legal term that means the point in time where property is earned or gained by some person.

In practical terms, many employers grant stock options or restricted stock as part of their compensation plans that are accompanied with vesting schedules, which means the employee needs to hit certain achievements in order to gain the right to own the shares.

  • Employee Stock Options (ESOs) : For ESOs, when stock becomes fully vested, the employee has earned the right to an option to purchase the shares that were granted to them in the past.
  • Restricted Stock Units (RSUs) : For RSUs, when stock becomes fully vested, the employee has earned the ownership of the shares outright.

Here is an article on employee stock purchase plans.

Vesting Stock Explained

For stock options, like incentive stock options or non-qualified stock options , an employee earns the right to purchase shares at a preset price in the future. In order to earn this right, they need to let the stock options vest.

For restricted stock units , an employee takes ownership of the stock once it becomes fully vested. Before stock is fully vested, it is considered vesting stock .

Vesting is commonly tied to time, but can also be tied to certain milestones. For example, vesting stock may become fully vested after four years, with shares becoming incrementally vested on shorter timeframes. Vesting stock can also become fully vested when an employee completes certain tasks or hits certain milestones.

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Before stocks are fully vested, an employee does not have the right to purchase them or own them.

Types of Vesting

Vesting is a common way for employers to incentivize employees to achieve certain milestones that help their business before issuing the employee stock. There are three main types of vesting.

Time-based Vesting

Time-based vesting is exactly what it sounds like. In order for an employee to gain the right to the stock, they will need to stay at the employer for a certain amount of time.

It is common to see a four-year vesting schedule tied to stock options with a one-year cliff. This simply means an employee needs to stay for a minimum of one year to earn any shares, and will have fully vested shares after four years of service.

Milestone-based Vesting:

Milestone-based vesting is not tied to time, but rather a value-creating task completed by an employee that would trigger the shares to vest.

One example of this may be a software developer completing a version one of a software product for their options to vest. There are many other examples of how this can be set up, and some think it is a better way of setting up vesting stock since it isn’t tied to an arbitrary metrics like time.

Hybrid Vesting:

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Hybrid vesting is simply a mix of the two. An employee will need to spend a certain amount of time at an employer AND complete certain value-creating tasks in order to earn the right to the shares.

Here is an article on the different types of vesting.

What Is A Vesting Schedule?

A vesting schedule is the term in the stock-based grant that outlines when the stock will be considered vested and the employee earns the right to purchase or own the stock. For example, if you receive stock options with a vesting schedule of four years, after the four years you will have earned the right to purchase all of the options shares at the pre-set exercise price.

What’s a typical vesting schedule?

An example of a typical vesting schedule is time-based for four-years with a one-year cliff where 1/4 of the shares vest after one year. After the one year, 1/36 of the remaining options shares will incrementally vest each month.

For example, if you have been granted 1,000 option shares with the above vesting schedule, and end up staying for 1.5 years, 375 option shares would have vested.

  • One-year = 250 shares
  • One-half year = 125 shares
  • 250 shares + 125 shares = 375 shares

Here is an article on how vesting schedules work.

Read more: The Average 401(k) Balance By Age | Bankrate

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Vesting Stock Example

Let’s go over a real-life example to better understand vesting stock. Below awe will outline a fairly normal employee stock option situation so you can better understand vesting.

Vesting Terms of the Employee Stock Options

  • Grant Date: January 1, 2020
  • Number of Shares: 10,000
  • Vesting Schedule:
    • Four-year vesting schedule
    • One-year cliff
    • 1/36 of the remaining shares vest monthly thereafter

Vesting Stock Scenarios

  • Employee leaves after 6 months
    • In this scenario, if an employee leaves after six months of service, zero shares would have vested.
    • This is because of the ‘one-year cliff’. Essentially, if the employee does not stay a minimum of one year, then they are not entitled to any of the option shares.
  • Employee leaves one year
    • In this scenario, the employee would have earned 2,500 shares.
    • This is because one year is 25% of the vesting schedule, thus earnings 25% of the option shares.
  • Employee leaves after 30 months
    • In this situation, 6,250 shares would have vested.
    • This is because the employee would have earned 2,500 shares after year one, which leaves 7,500 remaining shares. The employee stays for another 18 months out of the remaining 36 months, which means they would have earned 1/2 (18/36 = 1/2) of the 7,500 shares, or 3,750 shares.
    • 2,500 + 3,750 = 6,250 shares vested.
  • Employee stays forever
    • In this situation, the employee would have had the full 10,000 shares vest.

Vesting and Stock Options

Stock options are different than restricted stock, in the sense the employees earn the right to purchase the shares are a pre-set price, or exercise price. In order for the employee to exercise their options, the stock options will have need to vested.

Vesting schedules are set up as part of the legal agreement for employee stock options. Once stock is vested, the employee has earned the right to exercise the options.

Here is an article on employee stock options.

Getting Help Understanding Vesting

Vesting stock can be a difficult topic to understand. If you have any questions about vesting or want a lawyer to review your stock options agreement, feel free to post a project in ContractsCounsel’s marketplace to get free bids from lawyers on our platform.

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