Understanding Vesting: What Is a Vesting Period and How It Works

This webiste provides information how vesting works, why it is important in the context of ESOP and VSOP as well as different types

What is vesting and how vesting works

Vesting refers to the process by which employees earn the right to own the grants allocated to them as part of the employer contribution in terms of a share-based payment plan. In simpler terms, it is the mechanism that determines when employees actually gain ownership of the grants.

In contrast to a retirement plan all ESOP/ VSOP require vesting

Vesting schedule

The vesting schedule is a timeline or plan that dictates when an individual gains full ownership of benefits, such as employer-provided stock options, retirement plans, or other forms of compensation. Under a such a schedule, the employee earns these benefits gradually over a set period.

Vesting period

The vesting period refers to the period during which an employee has to fulfill certain conditions to become entitled to receive benefits, such as shares, options, or other equity-based payments. The period typically starts on the grant date (when the employee is promised the award) and ends when the employee satisfies all vesting conditions, after which the benefits can be exercised or accessed.

Understanding vesting and types of vesting schedules

In the following part we describe different types of vesting, how they differ and what factors determine the vesting. Understanding the different types of schedules is essential for both employers and employees, as they dictate how and when these benefits are acquired. In this chapter, we will explore various vesting schedules, how they work, and their implications on long-term financial planning. Whether you’re an employee looking to navigate your compensation package or a business owner structuring equity rewards, a clear grasp of vesting schedules is vital for informed decision-making.

There is no such thing like common vesting for stock options

Pro rata vesting conditions

Pro rata or linear 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 linear 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 conditions

This typ of vesting involves a single, specific 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 have to remain with the company for three years before any of their options become unforfeitable. After the third year, all options granted on the grant date become fully vested.

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 conditions

Milestone-based 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.

Graded vesting

Graded vesting combines both linear and cliff vesting elements. Employees become eligible to exercise a portion of their options over time. Unlike traditional pro rata 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.

Rateable/linear vesting conditions

A Ratable schedule 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% 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.

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.

Good and Bad Leaver in the context of vesting

The Good Leaver and Bad Leaver principles are used in the context of equity compensation plans, particularly when an employee departs from a company before fully vesting in their benefits (such as stock options or shares). These principles determine how much of the unvested equity the employee is entitled to retain based on the circumstances of their departure.

Good Leaver

A Good Leaver is typically an employee who leaves the company under favorable conditions, such as retirement, death or disability redundancy (layoffs due to restructuring), mutual agreement with the company departure after fulfilling most or all service or performance conditions. In such cases, the employee is often allowed to retain a portion or all of their unvested equity. The specific terms vary depending on the company’s plan, but common outcomes include pro-rata vesting or accelerated vesting.

Bad Leaver

A Bad Leaver is an employee who departs under unfavorable circumstances, such as resignation without good cause, termination for cause (e.g., misconduct, breach of contract, poor performance). A Bad Leaver generally forfeits all unvested equity, regardless of how long they have been with the company. In some cases, they may also be required to return already vested shares or options, depending on the severity of the cause for termination.

Key considerations

The Good Leaver/Bad Leaver distinctions are typically outlined in employment contracts or equity award agreements. These provisions are designed to incentivize loyalty and performance while protecting the company from rewarding employees who leave under negative circumstances. In the case of private companies, especially start-ups, Bad Leaver provisions are stricter to safeguard equity distribution. Ultimately, these principles create a structured approach to determine how an employee’s exit impacts their unvested equity.

Vesting

Vesting conditions within ESOP