When employees participate in stock option plans or accept stock options as a form of compensation, businesses enforce what they call a vesting period. This period is usually a number of years participating employees must work for the company before they can receive the full benefit of their option shares.
About Stock Options
Stock options give employees the opportunity to purchase a specific number of corporate stocks sometime in the future. The price at which they exercise their stock options and purchase shares is set on the day the company issues the stock option. Investors often refer to this as the grant or strike price. Employees do not have any stock ownership benefits, such as voting rights, until they exercise their option to purchase shares. Only after the employee exercises his option to purchase shares does he have the right to vote as a corporate shareholder as well as the right to buy, sell and transfer his shares.
Each company is different regarding its stock option vesting periods. Employers note the exact vesting date on the stock option contract or agreement. Generally, the employee does not have to exercise her options on the exact date the options fully vest. Many employers give a specific period in which employees can exercise their stock options after the passing of the vesting date. Options agreements also may have an expiration date when the options contract voids and the employee no longer has the right to exercise her options at the original grant or strike price.
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Cliff vesting occurs when the employer sets a specific period in which an employee must work for the company before his options fully vest. If he continues to work for the company until the vesting date, he can exercise his options contract and purchase company stock shares for the grant or strike price. If he quits or the employer terminates him before the date the options fully vest, he forfeits his options contract.
In gradual vesting, the employer sets specific vesting percentages during the vesting period. For example, if the vesting period is five years, the employer may set a vesting rate of 20 percent per year. This means for every year during the five-year period in which the employee continues to work for the company her vesting percentage increases by 20 percent, and she becomes fully vested at the five-year mark. If she leaves the company before the five-year vesting period ends, she can only exercise her percentage of vested options. In this example, if she left the company after two years, she has the right to exercise 40 percent of her stock options and forfeits the remaining 60 percent.