Equity vesting types, working and purpose

Equity compensation indeed helps companies hold on to their best employees. But, if employees or any shareholder could instantaneously convert their stock options into equity, ESOPs and other stock-based incentive systems would fail to retain them. That is why there is a set “vesting schedule” for stock options.

When planning your equity compensation allocation and long-term investments, it’s helpful to understand the purpose of equity vesting and how different types of equity vesting work.

To know more on the types of equity vesting and how you can implement the allocation to make sure the financial and operational success of your firm – Read along!

Equity Vesting

Equity vesting is when an employee or other stakeholder becomes eligible to receive company stocks. This usually happens over time and can be conditional on long-term employment or reaching specific performance goals.

Employees do not become full owners of their equity grants until the vesting period has passed. Alternatively, a schedule specifies when ownership rights will become effective and when an employee will have access to a certain percentage of their equity, whether that’s monthly, quarterly, or once a year.

Types of Equity Vesting

You can implement a vesting schedule for your employees and other stakeholders depending on your business needs. Here’s a list of the types of equity vesting.

Time-Based

The majority of vesting plans use a time-based vesting schedule. In most stock option plans, employees earn their options over time, with the first option granted and exercisable during a set period known as the cliff.

For example, for their performance, an employee was granted 9,000 stock options on the 1st of January, 2024, and these options take 3 years of vesting wherein the first year is a cliff.

This means that after one year of effectiveness in the performance of services, the employee is to be granted 33% of his options.

Milestone-Based

Under a milestone vesting schedule, employees or the company as a whole gain access to shares upon meeting certain performance goals or benchmarks. Some employees also implement schedules based on project completion.

Take for example, an employee is granted 9,000 stock options based on achieving three key milestones:

These types are often created for senior executives; performance benchmarks rarely determine vesting for less experienced workers.

Hybrid Vesting

With hybrid vesting, the best features of both time-based and milestone-based are available. In this scheme, employees can only exercise stock options if they’ve worked for the company for a specific amount of time and achieved a specific milestone.

Considering the combination of the above two examples, for Hybrid Vesting, where 50% of options (4,500) would follow a time-based schedule and the remaining 50% of options (4,500) would be tied to achieving milestones such as securing 100 clients and generating $3M as annual revenue.

This strategy works because it captures the best of both options offered by the two vesting options. The company can reward employees for their tenure and motivate them to work on critical goals.

Accelerated Vesting

When an employee participates in accelerated vesting, their restricted-stock units (RSUs) or stock options vest earlier than anticipated. This typically occurs when the company experiences a change in leadership, such as an M&A (Mergers and Acquisition or initial public offering (IPO).

Considering an employee who currently has 9000 stock options, that will vest for 3 years. However, his company is eventually bought out in the 2nd Year and he loses his job through the process. Immediately there is a change of the vesting schedule to ensure he vests his options to the fullest of 100%.

Moreover, in the same vein, it’s good for business since it aids talent retention and encourages important staff. Accelerated vesting can work against the corporation, but excellent equity management can mitigate this.

How Equity Vesting Works

Understand how the types of equity vesting work before incorporating them into your business plan.

Grant Date and Start Date

The grant date is when you issue stock options to your employees or other stakeholders, whereas the start date is when the vesting schedule begins.
The date of the grant significantly impacts when your options will vest. Postponement of the grant date will likewise postpone the vesting schedule.

Vesting Schedules

This refers to the period employees can exercise perks like equity. Employers with employee stock ownership plans, or ESOPs, typically establish a timeline that encourages staff members to stay in the workforce. This could entail giving employees more shares or options after they have worked for a year.

Vesting Percentage

An employee’s ownership share is their percentage. For instance, after two years, an employee may become fully vested in 20% of the company’s retirement savings plan contributions; after four years, that number rises to 60%; and after six years, it increases to 100%. The employer cannot withdraw the remaining balance from an employee’s account once they have reached 100%.

Vesting and Leaving the Company

Whether voluntary or involuntary, leaving the company has a major effect on when equity vests. Employees usually take their vested equity with them when they leave their jobs.

Depending on the rules, forced termination can grant additional rights to unvested stock or expedite vesting, but voluntary termination typically involves giving up unvested shares.

Purpose of Equity Vesting

Now that you understand how different types of equity vesting work, let’s see the purpose behind its implementation.

• Employee Retention – One way to keep employees committed to the company is by providing them with opportunities to own shares or stock options. Employees must stay with the organization for the whole vesting period if they want to use all of their options. The purpose of this is to encourage employees to remain with the company until the vesting period concludes.
• Performance Incentives – When you offer your employees vesting stocks, you incentivize their efforts. This aligns company objectives with employee performance and helps your employees accomplish long-term organizational goals.
• Company Stability – As an employer or key investor, you may often find certain short-term employees. Such personnel will not be of any use to an expanding company. But, when you tie their stock vesting to their performance or tenure, you can make sure they stay committed.
• Attracting Top Talent – A skilled employee looks for a competitive package and an organization willing to invest in their future. So, they find your offer attractive when you offer performance-based or other milestone-based vesting options.

Best Practices for Implementing Equity Vesting

Craft equity grants that serve dual purposes as incentives for workers and business gains. Here are some best practices when giving out stock grants with cliff vesting.

• Clear Communication – The first step is establishing effective communication with your team. Make sure everyone understands the cliff vesting process and its specifics, such as when it will begin, who is eligible to participate, and what the benefits are. Make sure your staff knows they can ask you anything, and be there for them every step of the way.
• Customization Based on Roles – No two employees are the same, and a one-size-fits-all strategy is unlikely to inspire and keep your best employees. Cliff vesting plans should be customized to meet each employee’s demands. Make sure you offer a mix of rewards to stay flexible.
• Regular Reviews and Adjustments – You should routinely assess your cliff vesting policies to make sure they are still up to date and effective. The best way for businesses to find and fix problems is to review their strategy often. For instance, if workers are uninspired by the present scheme, the employer can change the timetable or equity to suit their demands.
• Legal and Compliance Considerations – The types of equity vesting you offer your employees and stakeholders must comply with relevant laws and regulations. If you want to avoid legal issues, consider partnering with an expert consultant. They can offer you and the participants ongoing guidance and support through the schedule.

Consult experts for your equity vesting

Startups can benefit from share vesting in several ways, including lowering cash outflow, growing the company, and retaining talented workers. However, as with most entrepreneurial matters, it should be approached strategically to gain the most benefits with the fewest risks.

Another important aspect here is tax planning. You must consider tax consequences and strategies of your equity decisions. To help you make educated financial decisions about equity, Eqvista has experts who identify opportunities and threats.

If you want more accurate financial planning, Eqvista can help you get there. To top it all off, our corporate tax advisory services will assist you in maximizing your earnings while minimizing your tax burden. We offer research-based insights and comprehensive tax preparation to help you succeed in complex financial situations. Call us now to implement an informed equity vesting decision for your company!