Got offered a grant by your employer company but not sure how it works? We've got you. Capdesk explains stock vesting, how vesting schedules work, when you can exercise your options, and more - in simple terms as usual!
Stock Vesting Explained (In Brief)
An increasing number of companies (often but not exclusively startups), will offer employees equity as part of their compensation package.
It is important to understand that equity comes in different shapes and forms - the equity that you as an employee have received is most likely different the type of equity held by investors, which in turn might differ from founders’ equity, and so on.
Most commonly, the key characteristic of employee equity is that it vests gradually.
What does vesting mean?
It means that when you are given equity, you are not handed a part of the company in the very moment you sign your contract. Rather, what you’re signing is an agreement with the company that you are entitled to buy a certain number of shares in the company, for a pre-agreed upon price (called ‘the exercise price’), when certain conditions are met in the future. The fulfillment of those conditions is what we broadly refer to as vesting.
What Is a Vesting Schedule?
Your compensation package, including any equity it entitles you to, is meant to motivate you to perform as highly as possible and to stay with your employer for as long as possible.
That’s why it makes sense for your employer to show you upfront what you could be rewarded with - by offering you a grant - but only letting you reap these rewards over time. Every employer will design their own plan of how much equity you should be allowed to buy in the company, and over how many intervals or period of time. This is called a vesting schedule.
Types of Vesting Schedules
Time-based vesting is probably the most common type of stock vesting. The way it works is the following:
At some point in time (typically when you are hired or your contract is renewed), your company grants you a certain number of options, or other types of equity which vest over time. After that, for a fixed period of time, you will not be able to exercise (i.e. actually buy) any of the equity that has been granted to you. For example, many companies do not let you exercise your equity for the first year of employment - although this can vary vastly from one business to the next.
The end of this period is called a vesting cliff, and marks the point past which you are able to gradually exercise your equity.
Typically, your equity will vest cumulatively over fixed intervals of time after the vesting cliff. For example, you might be able to exercise 25% of your options after your first year at the company, 50% on the second, 75% on the third, and the full amount of equity on your fourth year with the business.
This type of vesting also allows you to exercise equity gradually, however in this case the marker for when you’re able to do so is a specific event rather than a fixed interval of time. For example, your company may pre-agree with you that you’ll be able to vets 10% of your equity once you hit a certain KPI, or once the company hits a certain target or stage in its development.
From the employer’s perspective, this focuses the motivational power of equity more on the employee’s performance rather than their loyalty to the company. However, it can sometimes be hard to measure certain milestones; or if these take to long to be materialised, employees might lose their hope and interest in actually claiming the value of their equity. This is why time-based vesting is often considered as a simpler solution by employers, and preferred over milestone-based vesting.
Of course, a company has the option of combining the two former types of vesting schedules into a hybrid type of vesting. This means that you’ll be allowed to exercise a certain percentage of your equity if a combination of time and performance related parameters are met. For example, it could be the case that your employer lets you exercise 25% of your equity at the end of every year, over a four year period, provided that by the end of every year you have met certain performance targets.
What Is An Exercise Window?
If at any time you decide to leave your employer company, and have not yet exercised some or any of your equity, you will be given a certain period of time to exercise your vested equity. This period is called an ‘exercise window’, and it typically lasts for 90 days (although this may vary from one company to the next, so make sure to check your grant agreement).
Let’s look at a vesting schedule example. Say you have a 4 year vesting schedule, whereby you’re able to vest 25% of your grant per year. You decide to leave in the middle of year 3. This means that \you’ve only vested 25% of your grant for year 1 + 25% for year 2. The remaining 50% that you were granted for years 3 and 4 automatically return to the company, as you haven’t stayed in the company long enough for them to vest. After your departure from the business, you have 90 days to buy the 50% vested equity of your grant for the exercise price that was pre-agreed upon in your grant agreement. If you don’t, that equity too will automatically be reclaimed by the company.
What Is A Stock Expiration Date?
Very simply, the stock expiration date is the date marking the end of your exercise window, after which any unexercised vested equity you were previously entitled to returns to the company.
What Is The Problem With Vesting?
The main problem with vesting schedules is arguably the lack of transparency or insufficient communication between management and employees. This means that, very often employees do not fully understand what they own in the company, or how the logistics of claiming the value of their grant work.
Capdesk aims to solve this problem by enabling companies to give employees live access to their vesting schedules, where they can track how much they’ve vested, how much it would cost them to exercise a certain number of equity at a given time, and how the amount of equity that they’re entitled to is affected by the company’s legal obligations to other shareholders.
If you’re company is not on Capdesk (yet!), do make sure to ask the person in your company responsible for employee share plans about what your equity’s current status is, and how you can utilise it moving forward. Company equity can potentially be an extremely valuable asset, especially if the business becomes a success over time. It would be a waste to overlook that you have a claim in your employer company, if this is indeed a part of the compensation package you’ve been granted. Make the most of it!