Vesting refers to the process by which the Option holder earns full rights to their Options, to allow them to be converted to stocks. Let's explore further..
How do the terms Exercise and Vest relate to one another?
Under an ESOP, an Option-Holder is not able to Exercise Options, until those Options have Vested. Until the Option is Exercised, the Option-holder does not have any stockholder rights (like voting rights, for example).So, until Options have Vested, the Option-holder can’t gain full rights to their slice of the cake.
What’s the purpose of Vesting?
Vesting is a little bit like dangling a carrot. The purpose of Vesting conditions is to tie some obligation of performance (or time) to the Options. It’s why ESOPs are such a powerful tool for incentivising your team to stay longer (and work smarter) towards the ultimate success of the company.
Time-Based Vesting can occur by way of a Cliff, Periodic Vesting, or a combination of both.
Think of a Cliff as the probation period for equity. It’s a period of time before any Options Vest. It’s usually set at one year, which gives the company time to see how the Option-holder performs, before they receive any equity. For example, if Tracey has a 12 month Cliff, 25% of her Options would Vest 12 months after her Start Date.
Periodic Vesting refers to Options that Vest gradually over a period of time (what we call the Vesting Period). For example, if Tracey has a 4 year Vesting Period after Tracey’s 12 month Cliff, the remaining 75% of her Options would Vest quarterly, over 3 years. So, at the end of month 15, another 6.25% of her Options would Vest.
The Vesting Period will usually start from the team member’s Start Date. It can also be set retrospectively, to reward for any time spent in the business prior to the Grant of Options.
Options will Vest on the achievement of some defined milestone or performance hurdle. For example, the remaining 25% of Tracey’s Options could Vest on her ‘recording $200k in sales for the company during 2021’.
Generally, Milestones are only appropriate when clear metrics can be defined. For example, a sales role where Vesting is tied to results.
The most common Vesting arrangements
The most common Vesting conditions we see are:
- 25% of Options Vest after a 12 month cliff;
- The remaining 75% of Options Vest quarterly, over 36 months after the Cliff Date.
You can have default Vesting condition set up in your Cake account or customise for each Option-holder.
Got more queries? Just ask – we love talking ESOPs. Don't forget to check out our ESOP terms cheat sheet to learn more equity lingo.
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- What are the benefits of an ESOP?
- How does an ESOP work?
- What is Vesting and how does it work?
- What are Plan Rules?
- What happens if an employee leaves?
- What happens if the company is sold or listed?
- What about selling options or stocks?
- How should I allocate options?
- How do I value a company for an ESOP?
- What are the regulations?