In Employee Stock Option Plans (ESOPs) vesting conditions determine when employees have earned the right to exercise their stock options. Vesting is designed to encourage employee retention and alignment with the company’s long-term goals. There are various types of vesting mechanisms, each with its own rules and implications.

Time-based vesting conditions

Time-based vesting means that employees become eligible to exercise a portion of their stock options over time, typically in equal installments on a regular basis.

Example: An ESOP might have a four-year time-based vesting schedule with a one-year cliff. This means that employees must work for the company for one year to become eligible for any options, and after that, they vest 25% of their options each year. If an employee leaves before one year, they receive no options; if they leave after one year but before four years, they keep the vested portion.

Cliff vesting involves a single, specific vesting date on which employees become eligible for a percentage of their options. Until that date, they have no vested options.

Example: An ESOP might have a three-year cliff vesting schedule. This means employees must remain with the company for three years before any of their options vest. After the third year, all options granted on the grant date become fully vested.

Cliff vesting conditions

Performance-based vesting conditions

Performance-based vesting ties the vesting of options to the achievement of predetermined performance goals or milestones. Vesting occurs when specific targets are met.

Example: A company might grant options to its employees based on achieving a certain revenue target or hitting a particular market share percentage. If the company reaches these goals within a specified timeframe, the options vest; otherwise, they may be forfeited.

Milestone vesting is similar to performance-based vesting but focuses on specific company milestones or events rather than financial metrics.

Example: An ESOP might include milestones such as achieving a successful product launch, reaching a certain customer acquisition number, or expanding into a new market. When these milestones are reached, the associated options vest.

Milestone vesting conditions

Graded vesting

Graded vesting combines both time-based and cliff vesting elements. Employees become eligible to exercise a portion of their options over time. Unlike traditional time-based vesting, they have some vesting even before the cliff date.

Example: A company may have a graded vesting schedule with a four-year term and a one-year cliff. In this case, employees might vest 25% of their options after one year and an additional 2.08% (25% divided by 12 months) each month thereafter.

Graded vesting is often combined with cliff period, when 25% of a grant vest after 1 year and the remaining 75% in quarterly tranches of 3 years following the cliff period.

Ratable vesting involves a straight-line approach, with options vesting incrementally on a monthly or quarterly basis.

Example: An ESOP with ratable vesting may grant options over four years with 25% vesting each year. This means that for each month an employee remains with the company, they earn 1/48th (25% divided by 12 months) of their options.

Rateable/ linear vesting conditions

Immediate vesting

Some ESOPs have immediate vesting. This means that all options are fully vested upon grant, and employees can exercise them immediately.

Example: A startup might choose immediate vesting for its small team of early employees as an incentive to join the company.

For other ESOP features, please visit our corresponding knowledge website.