What is Vesting? What Does it Mean For Employees

  • Written Written by Equity team 02 February 2023 | 4 min read
  • Editor's Note :

    Vesting can have a significant impact on an employee's financial future. It's important to understand how vesting works. Read this article for the Best guidance.

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It is nothing but a legal term that earns a right to a present or future payment, asset, or benefit for the employee. Vesting simply means the milestones which need to be achieved in order to have the rights on the employee stock ownership plans granted to an employee. Vesting can be linked with certain timelines or certain targets. For example - 25%_Annual Vesting_4_Yr i.e. The options will be vested @25% each year for the next 4 years.

TYPES OF VESTING

Time-based Vesting

It is a method of vesting through which employees can earn their share of stock options over time, and that time is generally based on a schedule and a cliff. Depending on the vesting schedule the remaining options are vested on a monthly, quarterly, yearly, etc. basis after reaching the cliff. In India, the minimum Cliff (Cooling period) is 1 year, i.e. the 1st Vesting of the Options Granted cannot be done before the end of 1 year from the Grant Date.

Milestone-based Vesting

It is the method of vesting where the employer grants stock options or benefits to the employee based on the fulfillment of specific tasks or the accomplishment of certain objectives. The employer may also set a milestone that appeals to the whole business and grant stock options to the employee who pitches in to reach the goal. For example - If anytime in the next 2 FY, the share price will remain @ INR 60K on the stock exchange for 15 days continuously then the vesting will happen otherwise all the options will lapse.

Hybrid Vesting

It is the mix or combination of both time-based vesting and milestone-based vesting. In this method of vesting, to be entitled to an exercisable employee stock option, the employee must stay at the company for a certain period and also stick out a particular goal or milestone.

Creation of Vesting Schedule

The vesting schedule is a schedule that is the specific rundown of when the Employee will be having the rights over the Granted ESOPs. There are three approaches that an employer takes to vesting;
“ Immediate Vesting, Cliff Vesting, and Graded Vesting.”

vesting schedule

Immediate Vesting Schedule

This is the most favorable kind of vesting schedule from employees' point of view as after the Cliff (if any) the options will be fully vested. For example - Mr. X receives 1000 ESOPs from his organization with an Immediate Vesting Schedule (Cliff 1 Year & Grant Date 01st April 2021). Now after the 1-year cliff or at the 1st Vesting Date i.e. 01st April 2022, Mr. X is entitled to exercise all the 1000 ESOPs.

Cliff Vesting Schedule

It transfers 100% ownership or full ownership to the employee in one big lump after a certain period. An employee will have no right over the stock option if he leaves before that certain period.
For Example - If in the above example, Mr. X was entitled to receive 100% of his ESOP after the completion of 3 Years from the Grant Date, then the 1000 ESOPs will be vested on 01st April 2024 and if Mr. X leaves the organization before 01st April 2024, then all 1000 ESOP will be Lapsed/Forfeited by the Organisation.

Graded Vesting Schedule

This type of vesting gives employees progressively increasing ownership as their length of service in their company increases, resulting in 100% or full ownership. And this is the most commonly used vesting schedule type. This vesting occurs gradually according to a pre-decided schedule. There is usually an initial one-year cliff period and during that period the ESOPs are not vested at all.
For example - 25%_Annual Vesting_4_Yr_1 Yr Cliff i.e. The options will be vested @25% each year for the next 4 years after a Cliff Period of 1 Year

Why would a company use Share Vesting?

Share Vesting can help a company accomplish three major goals:

Stimulating long-term commitment to the company,

Exhibiting a commitment to company growth,

Defending the company in case the relationship doesn’t work out.

Why do employers need vesting periods?

Benefits and Drawbacks for Employers in Vesting

Vesting for Start-Ups

For a Start-Up environment in which it is highly dependent on a very small number of employees, vesting is a vital way for the betterment of the business and will also protect the business and enhance sustainability. By providing a vesting schedule, the employees will stay longer in the organization and be loyal to the company.

In Conclusion

When a company wants to grow, especially when it is a start-up, share vesting is a very vital tool that incentivizes and retains the employees and protects the limited capital of the organization.

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