Stock vesting plays an important role when offering employees equity compensation as part of their compensation package. Why does it matter? It determines when an employee will earn full ownership of their equity, and therefore can act as a useful tool to encourage employees to stay longer at the company.
In this post you’ll learn:
What is stock vesting?
Stock vesting is the process of gaining ownership of an equity award by meeting certain conditions, e.g. length of employment or specific milestones.
Often, when an employee is granted equity on day one, they won’t have full control over it until the vesting period has passed. Only then will they earn the vested portions of the asset and be in a position to exercise (i.e. purchase) and/or sell it.
How does vesting work?
Vesting works by setting up criteria for earning an asset. If the criteria haven’t been met, the stock is not yet vested and thus not your asset. Here are the three main vesting criteria:
– Milestone-based vesting: Milestone-based vesting is when a recipient earns his/her asset after a particular milestone such as an IPO, or hitting performance targets. For example, your Head of Sales may become 100% vested when he hits a target of $20M in revenue.
– Time-based vesting: Time-based vesting is when a recipient earns an asset (such as stock options) over a specific period of time. For example, if an option has a 3-year vesting period, the recipient will need to wait 3 years to gain the right to exercise (i.e. purchase) all of the options. The process can occur on one given date or in intervals. Learn more in the following section ‘vesting schedules’.
– Hybrid vesting: Hybrid vesting is a combination of time-based and milestone-based vesting. It means a recipient needs to wait until both requirements have been met before they become an owner of their equity.
Vesting heavily determines the attractiveness of equity compensation and the effectiveness of staff retention. Speak with us today if you have any questions about vesting.
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Vesting schedules: Cliff vesting, Graded vesting & Immediate vesting
A vesting schedule typically comes in three types. The example below clearly shows how each type works.
| Full Years(s) of Services | Cliff vesting (over 3 years) | Graded/ratable vesting (over 6 years) | Immediate vesting |
|---|---|---|---|
| 1 | 0% | 0% | 100% |
| 2 | 0% | 20% | Nil |
| 3 | 100% | 40% | Nil |
| 4 | Nil | 60% | Nil |
| 5 | Nil | 80% | Nil |
| 6 | Nil | 100% | Nil |
Cliff vesting:
It’s a process where a participant receives full award ownership in one go at a given date. Imagine you offer your employees 300 shares with a 3-year cliff vesting schedule. They cannot exercise any of them until 3 years later, unless early exercise is allowed. After three years, when they become fully vested, the employees can then exercise them at the initially agreed price (i.e. exercise price) and sell the shares.
Graded vesting:
It’s a process where a participant gains award ownership in intervals. Again, imagine your employees are each offered 300 shares of stock options with a graded vesting period of 6 years. After the first year of employment, they would each receive 60 vested shares (20% of the total shares) which fully belong to them and they can exercise and sell at this time. The next year they gain a further 60 shares, and 60 shares the next year and so on.
Immediate vesting:
With an immediate vesting approach, a participant receives 100% ownership of their shares at the grant date. It means they can exercise or sell the shares right away.
Head over to our ”Vesting Schedule Examples” article to learn more about the trends and practices that companies are using.
How stock vesting affects employees when they quit?
If an employee quits but only a portion of equity has vested according to the vesting schedule, then typically only the vested equity can be kept by the employee while the unvested equity will be forfeited. A good rule of thumb is to include the vesting and termination rules explicitly in the equity agreement whether you are following the common practice or not.
Stock options and job departures:
Say a participant is granted 300 shares of stock options with 3-year cliff vesting.
If they leave before they hit the 3-year mark, they typically won’t get any shares. If it’s graded vesting and only 100 shares are vested before they leave, then they generally earn the vested stock options (100 shares) but not the remaining (200 unvested shares).
No tax is due at vesting for stock options.
Note: Incentive stock options typically expire within 90 days of leaving the company, so employees could lose their vested stock options if they don’t exercise them within 90 days.
RSU and job departures:
The RSU vesting mechanism works similarly – you’re only able to take the vested equity with you if you leave, but unlike with stock options, you’ll owe income tax when your RSU vests.
If your company is private when it vests, you’ll then need to pay the tax out of pocket because private companies lack liquidity. So, it’s not uncommon that RSUs in private companies are subject to ‘’double-trigger’’ vesting. This means two vesting criteria (usually one time-based requirement and one milestone-based requirement, e.g. IPO) have to be satisfied before the shares are truly yours.
So, with the ‘’double-trigger’’ mechanism, you should be able to sell your stock to pay any tax due at vesting.
How we can help with stock vesting
At J.P. Morgan Workplace Solutions, we’ve helped companies of all sizes and locations to launch their equity compensation plans.
Our purpose-built platform helps streamline equity administration, including managing multiple vesting schedules and rules. Through the J.P Morgan Workplace’s equity compensation software, you can easily set up, track and automate all your schedules and rules from one secure place, meaning less time is spent on administration and managing messy spreadsheets.
Contact us for a free demo today.
FAQ about stock vesting
What does vesting mean?
Vesting is the process of gaining ownership of an asset over time. An employee generally won’t have full control over the asset until the vesting period has passed. Once it has passed, the asset belongs to the employee and can be exercised and/or sold.
What is a vesting schedule?
This is how the recipient can gain asset ownership rights over time. There are typically three approaches – cliff vesting, graded vesting, and immediate vesting. Awards of stock, stock options, and RSUs are almost always subject to a vesting schedule.
What happens to vested stock when you quit?
This will depend on the actual rules set out by the individual company when establishing their equity compensation plan but typically you can keep the vested equity while the unvested equity will be forfeited (and will usually return to the company stock pool). Stock options typically expire within 90 days of leaving the company, so you could lose the vested options if you don’t exercise them within 90 days.
Please Note: This publication contains general information only and J.P. Morgan Workplace Solutions is not, through this article, issuing any advice, be it legal, financial, tax-related, business-related, professional or other. J.P. Morgan Workplace Solutions’ Insights is not a substitute for professional advice and should not be used as such. J.P. Morgan Workplace Solutions does not assume any liability for reliance on the information provided herein.
