Vested Stock Options: Definition and Types of Vesting Schedule

By: AJ Ayers, CFP®

401(k) plans often wait years to fully own employer contributions, with vested stock options serving as complex but potentially lucrative benefits that encourage long-term employment and align employee and company interests. Let’s talk about what vested stock options are and explore the different types of vesting schedules and its impact.

How long are you willing to wait to fully own your retirement savings? The answer for American workers enrolled in 401(k) plans could be up to 6 years.

New data reveals that only 30% of 401(k) plans offer immediate vesting of employer matching contributions. The remainder spread employer matches over vesting schedules - with some taking as long as 5-6 years to fully vest.

In today's competitive job market, employee benefits like stock options can be the golden handcuffs that tether talent to a company. But how many of us truly understand the intricacies of vested stock options and their corresponding vesting schedules?

In this article, we'll delve deep into what vested stock options are, explore the different types of vesting schedules, and examine their impact on both employees and employers.

Vested stock options are a popular form of employee compensation. They provide employees the opportunity to purchase company shares at a predetermined price after meeting specific criteria.

Let's break this concept down further for a clearer understanding.

In the context of employee compensation, vesting refers to the process through which an employee earns the right to exercise (buy) a certain number of company stock options granted to them as part of their compensation package.

The vesting process is governed by the terms of the employee stock option agreement.

Stock options can be subject to various vesting schedules, but one common structure is the graded vesting schedule.

In graded vesting, a percentage of options vest each year over a specified period.

For example, an employee might be granted 1,000 stock options, with 25% of them vesting on each anniversary of the grant date for four years.

Restricted Stock Units (RSUs) and Employee Stock Purchase Plans (ESPPs) are two other popular types of equity-based compensation subject to vesting. RSUs represent a promise of shares to be delivered at a later date, usually upon vesting, while ESPPs allow employees to purchase company shares at a discounted price through payroll deductions.

Once the vesting period is complete and an employee can exercise their stock options, they can choose to buy the company's stock at the exercise price specified in the stock options agreement.

This price is typically the market price of the stock on the date of the option grant.

The decision to exercise the options is often based on the current stock price and the potential for future growth in the value of the company shares.

It's important to note that vesting stock options provide the employee the right, but not the obligation, to buy the company's stock.

If the stock price falls below the exercise price, employees may decide not to exercise their options.

This is because they could simply buy the shares at a lower price on the open market.

What Is the Purpose Behind Companies Offering Vested Stock Options?

There are several reasons why a company might decide to offer these types of incentives, with some key objectives being to attract top talent, retain employees, and align employee interests with those of shareholders.

One crucial aspect of a successful employee equity compensation plan is incentivizing employees to stay and strive for the organization's long-term success.

Vested stock options serve this purpose well: generally, the longer an employee remains at a company, the more stock options they gain the ability to exercise.

Another reason companies use vested stock options as a form of employee compensation is their potential for significant financial gains.

As an employee's stock options become more valuable over time, it motivates them to work harder and contribute to the company's overall success.

Offering vested stock options also allows a company to conserve cash.

Instead of paying out more significant cash salaries, companies can use stock options to compensate employees, thus freeing up cash resources for other business purposes.

Furthermore, offering vested stock options can help companies recruit top talent in competitive industries.

A prospective employee might be enticed by the potential rewards from equity compensation, leading them to choose the job offer that includes such incentives over others without.


What Happens When Stock Options Vest?

When an employee is granted stock options, they often come with a vesting schedule. This means that over a period of time, the employee gains ownership of their stock options.

Once stock options vest, it means that the employee has the right to exercise their options and buy shares of the company stock at a predetermined price, known as the strike price.

Vesting schedules can vary depending on the company and the specifics of the stock option grant, but a common example is a four-year vesting period with a one-year cliff.

In this scenario, if an employee leaves the company within the first year, they would not have vested any of their stock options.

However, after the one-year cliff, 25% of their options would vest, and then typically, the remaining options would gradually vest on a monthly basis over the next three years.

If an employee leaves the company after some of their options have vested, they typically have a limited window to exercise their options and obtain company shares.

This window can vary but is often around 90 days.

If they choose, they can exercise the vested options and convert them into company shares, which they can hold onto or sell, depending on their financial strategy.

Exercising stock options can have tax implications as well, so it's essential for employees to be aware of this and plan accordingly.



Types of Vesting Schedules

When it comes to vested stock options, there are several types of vesting schedules that can be implemented. In this section, we will discuss three main types of vesting schedules: Time-Based Vesting, Milestone-Based Vesting, and Hybrid Vesting. Understanding these different schedules will help you make informed decisions when it comes to your stock options and financial planning.



Time-Based Vesting

Time-based vesting is the most common form of vesting schedule. In this case, a portion of your stock options will vest over a specified period, typically over a four-year vesting schedule. For example, a typical vesting schedule might have a four-year vesting term with a one-year cliff, meaning that 25% of your options will vest after the first year, and then the remaining options will vest monthly or quarterly over the next three years.

This type of vesting is often used by companies to encourage employee retention and loyalty, as the longer an employee stays with the company, the more options they stand to gain.



Milestone-Based Vesting

Milestone-based vesting, as the name suggests, involves options vesting upon the achievement of specific goals or milestones. These milestones can be company-related, such as reaching a specific revenue threshold, or personal, such as the completion of a crucial project.

This type of vesting is designed to incentivize employees to work hard and achieve significant objectives, while aligning the interests of employees and shareholders. It is important for both parties to agree on the milestones and the associated vesting to prevent misunderstandings and disputes.



Hybrid Vesting

Hybrid vesting is a combination of the two previous methods: time-based and milestone-based vesting. As such, a portion of the options will vest according to a time-based schedule, while other portions will vest upon the achievement of specific milestones.

For instance, a company could implement a hybrid vesting schedule with a four-year time-based term for 50% of the options, and the remaining 50% tied to specific milestones. This approach balances the benefits of both vesting methods, enabling the company to reward employees for their tenure while also incentivizing the achievement of crucial goals.



Difference between Cliff, Graded, and Accelerated Vesting

When it comes to employee stock options, understanding the vesting schedules is crucial. In this section, we will briefly discuss the three main types of vesting schedules: cliff, graded, and accelerated vesting.

Cliff Vesting is an all-or-nothing approach to vesting stock options. In this scenario, employees must wait a predetermined period (usually one to four years) before they are fully vested. If employees leave the company before reaching this point, they do not receive any stock options.

However, once the cliff vesting period is over, employees become fully vested and can exercise all their options.

Graded Vesting is a more gradual approach to vesting stock options. Under this schedule, an employee becomes incrementally vested over time until they are fully vested.

For example, an employee may become 20% vested after one year, 40% after two years, and so on. At each vesting milestone, employees can exercise a portion of their stock options assuming the stock market price is meeting their expectations.

Accelerated Vesting is a special circumstance where employees become fully vested at an earlier date than their original vesting schedule. Accelerated vesting can occur due to performance milestones, change in company ownership, or in some cases, upon the discretion of the company's board of directors.

The advantage of accelerated vesting is that it allows employees to access their stock options sooner, potentially locking in profits before market fluctuations affect the value of the stock. However, it's essential to consider the income tax implications, as exercising stock options can trigger tax liabilities.



Vested Stock Option Scenarios

Vesting Terms of the Employee Stock Options

  • Grant Date: July 1, 2021

  • Number of Shares: 12,000

  • Vesting Schedule:

    • Five-year vesting schedule

    • Six-month cliff

    • 1/54 of the remaining shares vest monthly thereafter



Vesting Stock Scenarios

Employee leaves after 3 months

In this scenario, if an employee leaves after just three months, they would not have vested any shares. This is because of the 'six-month cliff', which means the employee must stay for at least six months to be entitled to any of the option shares.

Employee leaves after 6 months

In this case, the employee would have earned 1,200 shares. This is because the six-month period is 10% of the five-year vesting schedule (6 months / 60 months = 1/10), thus earning 10% of the 12,000 option shares.

Employee leaves after 20 months

In this situation, 3,600 shares would have vested. Here's the breakdown:

  • 1,200 shares would have vested after the initial six-month cliff.

  • There are 54 months remaining in the vesting schedule after the six-month cliff, and the employee stays for an additional 14 months.

  • 1/54 of the remaining 10,800 shares (12,000 - 1,200 = 10,800) would vest monthly.

  • 14 months would mean 14/54 of the remaining 10,800 shares, which is 2,400 shares.

  • 1,200 (from the cliff) + 2,400 (from the additional 14 months) = 3,600 shares vested.

Employee leaves after 40 months

In this case, 7,200 shares would have vested.

  • 1,200 shares after the six-month cliff.

  • 34 additional months (40 months - 6 months = 34 months)

  • 34/54 of the remaining 10,800 shares would be 6,000 shares.

  • 1,200 (from the cliff) + 6,000 (from the additional 34 months) = 7,200 shares vested.

Employee stays forever

In this ultimate scenario, the employee would have had the full 12,000 shares vest.



AJ Grossan