Stock vesting is the process by which companies issue employees equity ownership gradually over a period of time. For startup founders, this is an essential factor to consider when evaluating compensation offers and for startup employees, when accepting such offers.
Knowing the mechanics of stock vesting can help you make intelligent financial decisions as a company and as an individual stock option holder. In this guide, we'll explain what stock vesting is, why it matters, and how you can use it to your advantage. Let's get baking!
Stock vesting explained
What is stock vesting?
Stock vesting is the process through which a stock option holder gains ownership of equity over time according to a predetermine vesting schedule. It's like cutting the cake into slices and only serving the option-holder one slice at a time, rather than giving them their whole share at once.
This gradual stake at the company's success incentivizes employees to stay with the company or maintain their investment.
If you're an employee, you are likely issued employee stock options (more common in early stage startups) or restricted stock units (more common in later stage startups). There are differences in the way ESO and RSU vest.
Vesting stock options
There are two main types of stock options: ISOs (incentive stock options) and NSOs (non-qualified stock options).
Incentive Stock Options (ISO)
These stocks give employees an incentive to stay with the company long-term. When they vest, they become eligible for preferential tax treatment.
This means any profits made when exercised will be taxed at a lower rate than what would happen if those gains were earned from other investments such as real estate or mutual funds.
On the flip side, if the stock is not vested, the employee may be subject to a penalty tax.
Non-Qualified Stock Options (NSO)
These options are often more flexible than ISOs and don’t come with any preferential tax treatment. When they vest, employees will have to pay taxes on their gains like any other type of investment.
Vesting restricted stock
Restricted stock units (RSU) is a restricted form of stock granted by your employer as part of your compensation package. The company must give you the shares when certain conditions have been met or vested. Once the waiting period is over, you can keep the shares and benefit from any increase in their value.
The main difference between RSUs and other types of stock options is that with RSUs, you don’t have to purchase the shares upfront.
This means that there's no out-of-pocket cost for you as an employee. However, since they are restricted, they can only be sold after a certain vesting period has been completed.
NSO/ISO vs RSU
Unlike NSO and ISO which may require employers to pay taxes, RSUs are only subject to taxation once they vest. There are pros and cons to using each of them so make sure you understand how they work.
How does exercising and vesting relate to one another?
Under an employee stock option plan, an option-holder is not able to exercise options until those options have vested. And until the option is exercised, the option-holder does not have any stockholder rights. So until options have vested, the option-holder can't gain full rights to their slice of cake.
Stock vesting terminologies
- Offer Letter means the agreement setting out the number of options being allocated, the vesting conditions, and relevant exercise and options price. In some jurisdictions this isreferred to as an equity agreement or an option agreement.
- Option means an option to purchase a stock. Until an option has vested and been purchased, it is not a stock. It is a legal right to purchase a stock at a later date, if certain conditions are met.
- Option-holder means any employee, advisor, or contractor who has been offered (and accepted such offer) options to purchase stocks under a stock option plan.
- Stock vesting date means the date the vesting period starts ticking. Typically this is the start date of employment, or whatever date was specified in the Offer Letter.
- Vesting period means the time from the stock vesting date (or start date) to the date the last options will vest under the agreed vesting conditions.
What is a vesting schedule?
Think of this stock vesting period like setting a timer on your cake - it helps define how long you need to wait before enjoying the full benefits of your stock option plan.
Through waiting, employees gradually earn their shares over time according to certain conditions (such as length of service or milestones reached). Once those conditions are fulfilled or “vested” in full, employees have unrestricted access to their stocks.
You can have a default vesting schedule set up in your Cake account or have it customised for each option-holder. Vesting conditions for a specific employee is set out in each individual Offer Letter. This way, the vesting conditions are unique to the option-holder, while the same general Plan Rules still apply to all. To make it sweeter, Offer Letter templates are available in the app too. Get started for free today!
Types of vesting
Now that we’ve covered types of vesting schedules let’s shift gears and explain three different vesting strategies.
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, let's talk about a hypothetical employee named Tracey. If Tracey has a 12 month cliff, 25% of her options would vest 12 months after her start date.
Graded vesting (or periodic vesting) refers to options that vest gradually over a period of time.
Going back to Tracey, if she has a 4 year vesting period after a 12 month cliff, the remaining 75% of her options would vest quarterly over 3 years. At the end of month 15, another 6.25% of her options would vest, and so on.
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.
In milestone-based vesting, options will vest on the achievement of some defined milestone or performance hurdle.
For example, Tracey has a goal of delivering $200K in sales for the company in 2022. The remaining 25% of Tracey's options would vest upon achievement of this milestone.
Generally, milestones are only appropriate when clear metrics can be defined. Like Tracey, a sales role where vesting is tied to results can qualify for a milestone-based vesting.
Hybrid vesting is a type of stock vesting that combines both time-based and performance-based vesting. Simply put, this means employees can earn their stocks over time and be rewarded for meeting certain milestones or achieving specific goals.
The plan rules set out what happens to unvested options in the case of an exit event.
Most plan rules contain an ‘Accelerated Vesting’ provision, which provides that in the event of an exit, all unvested options will automatically vest.
The logic here is to disincentivize employees delaying an exit event, to make sure their options have vested first.
4-year vesting, 1-year cliff
"4-year vesting 1-year cliff" is a common vesting conditions within employee stock option plans or equity agreements.
In this case, the vesting schedule has a duration of 4 years, which means that the employee's stock options will become fully vested after 4 years of service with the company.
The "1-year cliff" refers to the initial period where employees have to stay for a year before their stock options begin to vest. If an employee leaves before this period ends, he walks away without anything and the unvested options would be returned to the option pool.
After the cliff period, vesting typically occurs on a pro-rata basis, meaning that a percentage of the shares become vested over time.
For example, if an employee has 1,000 shares that are subject to 4-year vesting 1-year cliff, 25% of their shares would vest after the first year (250 shares). The remaining 75% would vest gradually over the next three years (250 shares each year).
Stock vesting made simple with Cake
The Cake platform tracks vesting, and automatically provides updates as vesting events occur.
Cake also notifies the company and option-holders each time a vesting event occurs, so they are always reminded of the options they're aaccumulating. A neat way to keep equity top of mind for teams.
Transparency on the Cake platform makes the options feel more tangible, and will avoid you needing to regularly provide updates to option-holders on their vesting status (admin can really take the fun out of sweet treats)!
FAQs on stock vesting
What does it mean to be vested after 5 years?
It means that after five years, you will have earned the full rights to your stock and be able to make decisions regarding it.
What happens if you quit before fully vested?
If you quit before your stock is fully vested, any unvested shares will be forfeited and cannot be used.
What happens to vested 401K when you quit?
When you quit, any vested 401K money that is yours to keep will remain available for you to access.
How long is the vesting period for stock options?
The vesting period for stock options typically ranges from one to four years.