Stock Vesting

If you are managing stock vesting in a company, by now you know how complicated, cumbersome yet critical this process is. Offering company shares to stakeholders requires a good understanding of the stock vesting process.

Vesting

Over recent years, many different forms of employee compensation have emerged apart from just a fixed salary. These alternative forms of compensation include options for employee ownership of the company, like stock options and stock awards. These strategies engage employees to provide their best work in return for a benefits package in the future. But they are often subject to vesting.

What is vesting?

Vesting is a process by which employees are granted non-forfeitable rights over benefits accrued during their time in a company. These assets can be in the form of employee contribution, employer sponsors, or a combination of both. The employee would receive a vested award normally in cash, stock vesting, health insurance, retirement plans, pension plans, and others. However, these vesting plans are subject to certain rules which protect the interest of all parties involved in the agreement, with common vesting periods being between 3 – 5 years.

Where is vesting commonly used?

Vesting helps in building an employee’s relationship with the well-being of the company. While salary compensation provides instant gratification, a vesting agreement aligns the employee’s interests with the company’s growth.

Startups use attractive stock vesting plans to recruit new talent which they could not have afforded otherwise with cash compensations. Employees stay invested in the company and take a share in the business profits over time. The vesting plans can be customized to suit the role of a startup.

On the other hand, large companies offer retirement benefits to employees, which are vested over their service period. For instance, in 401(k) plans where only employees contribute, they can take it all when they leave the company. But in plans where the company offers matching contributions, based on the vesting agreement, conditions will apply. The Employee Retirement Income Security Act (ERISA) has set rules which protect employee’s retirement assets. Sometimes performance incentives can be offered using vesting plans as well.

What is a vested benefit?

A vested benefit is the entire financial package received by an employee after the qualifying period. These terms are declared in a vesting agreement. This reward is called a vested benefit only when granted in full, and it is either granted all at once (cliff vesting) or in incremental credits (gradual vesting) eventually leading to a 100% ownership.

Stock vesting

Let us now look at vesting specifically using company stocks.

What does vesting mean in stock?

Stock Vesting is a non-forfeitable benefit offered to employees in the form of equity in the company. Some vesting is immediate i.e. the stakeholder receives complete ownership of the stock right away, while some other plans vest gradually over a certain period. In this case, a stakeholder is not granted immediate ownership of stocks, but only the right to exercise shares at a set price on a later date, once fully vested.

For example, Jack is offered 100 shares with a vesting period of 2 years. Jack will receive 100% ownership of all 100 shares only after the end of 2 years. If he leaves in between, he will have to forfeit all his shares. Meanwhile, Lisa is offered 100 shares with a stock vesting schedule of 4 years with one year cliff. After the one year cliff, Lisa will receive 25 shares every year for the next 4 years. If she leaves after 2 years, she can keep the 50 shares already vested. The unvested shares will return to the company option pool. But if Lisa continues her service, she will receive 100% ownership of all 100 shares at the end of four years.

How stock vesting works?

There are three common equity instruments with stock vesting are:

• Incentive Stock Option (ISO) – Employees are offered the right to buy company stock at a discounted price as compared to the market price. Once fully vested, by exercising these shares at a later date, employees gain from the differential pricing, with tax breaks available on profits. This type of stock vesting option is offered mostly to top management or highly valued employees.
• Non-qualified Stock option (NSO) – Employees are offered the right to buy company stock at a preset price, being mostly the market value of a share on the grant date. Employees have to exercise these options before the expiration date. The idea behind this stock vesting schedule is that company’s share prices will increase in value over time and the employee will profit from the differential pricing. However, as per this option, income tax has to be paid on the profits gained.
• Restricted Stock Units (RSU) – The employer vests a certain amount of shares to be qualified over time. This stock vesting period can last for years. Once fully vested, all benefits are treated and taxed as ordinary income for that year. A certain portion is withheld to pay income tax allowing the employee to use the rest as per their discretion.

In ISOs & NSOs, employees are required to buy stocks once fully vested, whereas with RSUs, the employer grants stocks and the employee only has to wait for them to fully vest.

Why is stock vesting important for Startups?

Startup founders operate on equity compensation and they must have clarity about their shares in company profits as early as possible. Stock vesting thus is an important component for the long-term success and stability of a startup. Since founders are highly valued resources who contribute intellectual property and know-how in the startup, in addition to gradually vested stocks, they come on board with a stock package as a sign-up bonus, which vests immediately.

With well-defined stock vesting schedules, founders gradually acquire 100% ownership over their vested shares. However, in case of a founder’s premature exit or incompetency, a startup reserves the right to forfeit a founder’s share and buy back the unvested portion.

Stock vesting is important for startups because:

• Motivation for long-term commitment – Startup life can be difficult. It is as good as nurturing a child. Startups operate in high energy, stressful environments, and require the team to multitask and sometimes take up responsibilities beyond their defined roles. Hence it is common for founders and other resources of the initial team to burn out and quit mid-way. Stock vesting in employees keeps them motivated towards collective profits in spite of all the hardships.
• Protection for the business – Imagine Jack and Jane start a company together. Both have 50% stakes. Over time Jane realizes that Jack is not holding up his end of the bargain. Or alternatively, Jack has to exit the company due to personal obligations. Jack leaves with a 50% share while Jane is left to take up the sole responsibility of the company. She is left with no resources to hire someone else either unless she foregoes a percentage of her equity. Jack and Jane could have avoided this situation with a stock vesting agreement. For instance, Jack and Jane could have signed up for 50% stakes with a 4 year vesting period. If Jack left in the 2nd year, he would have taken only 25% of his shares, leaving the rest for Jane to invest in other resources. Or the company could choose to buy back all of Jack’s shares.
• Investors prefer vesting – Startups boot-strap themselves into business. But past the initial stage, they have to approach angel investors and venture capitalists to scale-up operations. At this stage, stock vesting options are an indicator for investors to gauge the team’s commitment and ensure the protection of their equity from prematurely exiting founders. Established stock vesting plans help build faith in the company’s health. Hence it is better to have vesting documents in order from the very beginning of the startup operations.

Vesting Schedules

Stocks usually vest in three ways: Immediate vesting where employees gain 100% access to their shares immediately without any waiting period, Cliff vesting where employees gain 100% ownership after the cliff period, all at once, and Graded vesting where employees gain their shares gradually on an incremental basis over a period, eventually leading to 100% ownership. Vesting agreements define these terms in detail.

What is a vesting schedule?

A stock vesting schedule is a timeline indicating an employee’s ownership over vested benefits. Vesting schedules apply only for the company’s contribution towards an employee and helps the employer lay out all details of the rewards an employee will reap over time for their work in the company.

Commonly used stock vesting schedules for employees are 4 years long with a one-year ‘cliff’ period. A cliff is the time employees have to wait to qualify for the first vested stocks. After the ‘cliff’, all shares are vested in monthly installments over 4 years. If an employee leaves mid-way, they will be provided an ‘exercise window’ by which time they will have to exercise all their options or forfeit them. Similarly, once fully vested at the end of 4 years, employees have to exercise all their options before the ‘stock expiration’ date.

How are vesting schedules established?

There is no rule of thumb for vesting schedules. They are designed based on the type of business and scale of operations. However, federal laws dictate certain aspects of vesting schedules. A vesting agreement includes details of the vesting schedule.

Vesting schedules are approved by the board of directors, and in startups, stock vesting schedules must be established before any milestone events like product launches, scale-up, acquisitions, or IPOs. In case of acquisition possibilities, a startup must define an exit plan for founders as well.

Do all the employees have the same vesting schedule?

Not necessarily. The way employers customize benefit schemes for employees, vesting schedules depend on some factors like the employee’s caliber, contribution to the business, and their position in the organizational hierarchy. An employee’s role is different from that of a consultant while a director’s role is different from that of an advisor, and so on. Each one has their motivations to be with the business. Hence vesting schedules are customized to suit their needs. Some plans provide default vesting schedules that apply to everyone until a new plan comes into action.

Types of vesting schedules

Vesting schedules are of three types:

• Time based vesting – This is the most common type. Employees are allowed to exercise their shares after a certain period of employment in the company known as the ‘cliff’. For example, if Anne joins a company in June 2020 with 192 shares spread over a stock vesting schedule of 4 years, after the one year cliff, 48 shares (192/4) will be vested in her account in June 2021. Then on an incremental basis, 4 shares will be vested in her account every month for the next 3 years. Anne will have 100% ownership over all 192 shares in June 2024.
• Milestone-based vesting – Employees gain the right to exercise their shares gradually but not over a fixed time. Stock vesting, in this case, is defined by performance milestones. For example, if Jack, a business development manager is offered 100 shares based on milestone vesting, he might have agreed to terms such as receiving 25 shares for every 10 clients he brings on board.
• Hybrid vesting – As the name suggests, this is a combination of the previous two types. An employee can exercise 25% equity at the end of each year for 4 years provided they have met certain performance milestones.

Time-based vesting builds loyalty of the employees while milestone-based vesting focuses on performance. But milestone-based vesting is not often used because it takes time to realize and employees might lose hope over time. Hence time-based stock vesting schedules are preferable. Here is how a typical time based vesting schedule looks like:

Total no. of vested shares: 192 shares
Vesting period: 4 years
Cliff: 1 year

Time-Based Vesting: 

In this example we see how a 4 year time-based vesting schedule pans out. Let us assume an employee joins a company in June 2020. She is allotted a total of 192 shares in the company to be vested over 4 years. After the one year cliff, in June 2021, 25% of these shares (192/4 = 48) will be fully vested. After that, 4 shares will be vested in her account every month in an incremental pattern. Thus by June 2022, she would have received another 25% of the shares now totalling her vested shares to 50% ie. 96 shares. The same pattern applies over the next two years, amounting to her 100% ownership over all 192 shares by June 2024.

Typical vesting schedules for Founders

Founders are the reason a startup comes into being. Hence it is important to protect their interest at all times. As discussed in earlier sections, stock vesting schedules are one of the primary aspects founders must discuss when they get together to start a company. In addition to them having clarity about their shares, a well-defined stock vesting plan is needed to attract investors as well. It indicates the company’s operational stability and level of commitment from the founders.

Founders usually come on board with a percentage of stocks vested immediately as part of the sign-up package. The rest of the promised shares are vested gradually as per a stock vesting schedule, with these having specifically built-in exit plans as well, in case of acquisitions. This ensures protection for all their hard work up until that time. Their shares are accelerated based on these two terms:

• Single-trigger – On acquisition, all the unvested founder shares are vested immediately irrespective of the terms set out in their stock vesting schedules. Founders gain 100% ownership over all allotted shares and are free to leave.
• Double-trigger – On acquisition, not only all unvested shares are vested with immediate effect, founders have to be absorbed into the new company as it is. This protects their professional investment in the business, and the founder vesting agreements include all of these clauses.

Typical vesting schedules for employees

Vesting schedules for employees are simple as compared to founders. They usually span over 4 years with a maximum limit of 6. After the ‘cliff’, stock vesting happens with a standard monthly rate, with some plans having additional milestone-vesting as well.

Typical vesting schedules for consultants, advisors, directors

• Consultants – Typically these vesting schedules have no cliff and vesting agreements span over 12 – 24 months. Stocks vest monthly on a 1/24 basis. Sometimes milestone-vesting might be included depending on the consultant’s services.
• Advisors – Vesting schedules for advisors are similar to consultants, except that their stock vesting might accelerate towards the end of the vesting period. For example, in a 4 year vesting period, towards the end advisors might receive 3/48 shares every month.
• Directors – Vesting schedules for directors are similar to the employees and a ‘Cliff’ is included. But unlike employees, directors might receive a sign-up bonus and their shares might accelerate towards the end of the stock vesting schedule, similar to the advisors.

Stock vesting agreement

Since vesting schedules are customized for each contributing resource in the company, it is important that all terms are agreed upon in stock vesting agreements.

What is a stock vesting agreement?

A stock vesting agreement is a contract used by companies to sell their shares to employees or consultants. These agreements are part of the share purchase plan. It details all terms of stock allocation, stock vesting schedules, and return of unvested shares to the option pool in case the employee quits mid-way. A shareholder will be entitled to 100% ownership of their shares only if all terms mentioned in the stock vesting agreement are met.

Key points to be included in a vesting agreement

Basic points to be included in a vesting agreement are –

• Purchaser-employer relationship
• Type of vesting schedule
• Number and type of shares to be sold
• Total buying price of shares
• If all shares or part of it are subject to vesting
• Qualifying conditions for sale
• Exercise window in case of repurchase option
• Stock expiration date

Stock vesting calculator

In startups with a couple of founders, stock vesting can be easily calculated in an excel sheet. All you need to do is: (stock price) x (number of shares) x (vesting factor).

But in companies with a larger workforce, things will get complicated. Companies offer multiple rounds of grants to employees during their course of service. This means handling customized stock vesting schedules. Over time, it becomes difficult to track multiple schemes for many employees, and doing so on Excel becomes cumbersome. Adding to this are the needs of employees on termination plans where exercising dates have to be tracked. In such cases, it is advisable to use a captable system, like Eqvista, that make calculations easier and minimize errors.

Creating vesting schedules using Eqvista

Eqvista enables companies, investors, and company shareholders to track, manage, and make intelligent decisions about their companies’ equity. Stock vesting becomes easier, quicker, and less cumbersome. Using Eqvista, vesting plans can be created with ease. This step-by-step guide will help you understand how to create vesting plans on Eqvista.

Our cap table app supports both time based vesting and milestone vesting. Here is a how a typical vesting schedule with 10% vesting each month would look on Eqvista.

Alternatively, if you would like to have milestone vesting for meeting certain goals, you can also create this on Eqvista.

Here is an example of a milestone vesting schedule based on total sales. The percentage of allotted shares grows slowly from 1% up to 20% for the last vesting periods.

Once you have created a stock vesting schedule, the next step is to apply it on all stocks. This is how simple grant issuance can be.

If you want to know more or understand any other process, check out these support articles.

Conclusion

It is evident that vesting is the foundation of employee benefit schemes, and the vesting process assures an employee’s extended relationship with the company. When company stocks are vested in employees, they see their direct role in increasing company profits. The higher their contribution, the more business profits and better vested rewards they receive.

Create Vesting Plan on EqvistaGET STARTED, IT'S FREE!

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With the ease of our platform, you can issue electronic shares entirely online, to your founders, investors, employees, and set up a vesting schedule for each. Everything is automated, so you can manage everything in our platform, saving you time and money. If you are looking for more information, access our Eqvista support articles to know more about related topics or contact us today!