Businesses enforce a vesting period when employees participate in stock option plans or accept stock options as a form of equity compensation. Vesting means the process through which an employee earns the right to receive the full benefit of their stock option shares. A vesting period is often expressed in years of service with the company.
Why Vesting Date Is Important to Employees
Each company is different regarding its stock option vesting periods. The grant date of an employee stock option is the date the option is granted. The vesting date is the first date an employee can exercise the option. Once an employee exercises their option, they have full ownership of the stocks they purchase.
Many employers instate a vesting period, a period of time from that initial vesting date up to a determined expiration date when the options contract voids. At the end of that time, an employee no longer has the right to exercise their options at the original grant or strike price.
What Are Stock Options?
Stock options are a type of equity compensation employers can offer to allow employees to purchase a certain number of shares and share ownership interest in the company. It’s called an option because it is up to the employee whether to invest or not.
The valuation of the stock option depends on the difference between the employee purchase price and the market value after vesting. Stock options are typically treated as deferred compensation.
Stock options differ from profit sharing. Profit sharing is a retirement plan centered on employer contributions to employees’ tax-advantaged retirement accounts. The IRS has specific rules for when profit-sharing disbursements may occur and how they are taxed. However, the vesting rules for many retirement plans and pension plans are similar to those of stock options.
Stock Options vs. Restricted Stock Units
Both stock options and restricted stock units (RSU) are equity compensation offered as a benefit of employment. While these perks are very similar, they have a few distinct differences:
Stock Options | Restricted Stock Units | |
|---|---|---|
| Cost | Sold to employee at “strike price” – a fixed price set the day the stock option is issued. The cost may be less than market value. | No cost to employee. RSUs have no value until they vest. |
| Vesting | A vesting date is set in advance upon which an employee can exercise the right to purchase company stock | Shares restricted during vesting period, often released on graded schedule, determined by length of employment or predetermined milestones. |
| Shareholder rights | Shareholder benefits, such as voting, take effect when employee purchases shares. | Once vested, the stockholder has all rights of ownership. |
| Can stocks be transferred or sold? | Yes, once stocks are purchased | Yes, once vested. |
| What happens if employee's employment ends? | If an employee has not exercised their right to purchase stock options, and the period isn't expired, they may be given a time period within which stocks may still be purchased. | The vested portion is owned by the employee, but unvested portion is forfeited. |
| Taxation | According to IRS rules, stock options may be taxed when option is received, exercised, transferred or sold. | The IRS indicates that RSUs are generally taxed at vesting and when transferred or sold. |
What Is a Minimum Cliff Vesting Schedule?
Cliff vesting is when an employer sets a certain number of years of service an employee must have before options fully vest.
If an employee continues to work for the company until the vesting date, they can exercise their options contract and purchase company stock shares for the grant or strike price. Conversely, if they quit or are terminated before the date the options fully vest, they forfeit their options contract.
While, according to a typical vesting schedule, employees may not be fully vested for four years or more, some employers may offer a one-year cliff or immediate vesting as an incentive or hiring bonus. Startups with small teams often benefit from a cliff vesting schedule that encourages retention as shares vest.
What Is a Graded Vesting Schedule?
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, their vesting percentage increases by 20 percent, and they become fully vested at the five-year mark.
If an employee leaves the company before the five-year vesting period ends, they can only exercise a percentage of total vested options. In this example, if they leave the company after two years, they have the right to exercise 40 percent of their stock options and forfeit the remaining 60 percent.
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