When a company gives you stock options as part of your compensation package, they’re essentially offering you partial ownership. However, your options usually must vest first, meaning you need to work for the company for a period of time if you want to actually receive that ownership stake. Companies generally use vesting to encourage you to stay longer and/or perform well so you can earn the award.
By definition, vesting is the point at which an asset’s ownership is officially transferred. As it relates to compensation, vesting is the process of earning an asset that has been awarded to you pending the completion of stated objectives.
You can only exercise vested options, just like you can only take with you (upon separation) the employer retirement plan contributions that have vested. Upon leaving your company, any unvested options are returned into the option pool. (NOTE: Under unique circumstances, some severance packages do offer immediate vesting of all awarded, but not yet vested options.)
While there are complex regulatory guidelines around the structure of vesting schedules (generally to protect employees from excessively long vesting periods and to govern how compensation is recognized for tax purposes) there are still a myriad of ways in which each company can customize their vesting policy. Vesting schedules can even be customized on a grant-by-grant basis. These details should be thoroughly documented in each grant agreement and it is critical that you and your financial advisor review and track these details accordingly.
There are two primary types of vesting schedules: time-based and performance based.
TIME-BASED (by far the most prevalent)
With time-based stock vesting, you earn options or shares over time.
Most time-based vesting schedules use a vesting cliff. The cliff represents the time at which the first portion of your option grant vests. Following the cliff, you typically vest the remaining options on a recurring basis over the next several months, quarters, or even years.
Again, be cognizant of the fact that each option grant may have its own vesting schedule. Additionally, vesting isn’t based on your overall tenure at the company; the timeline for each grant begins when that specific grant is received. If you were awarded a grant in 2016 and another grant in 2018, with both having a four-year vesting schedule, you wouldn’t vest in all the options of both grants until 2022.
PERFORMANCE-BASED
With performance-based vesting, your options are received after completing a specific objective or when you and/or the company reach a stated objective (e.g., the company reaches a certain valuation, sales grow by a certain percentage, etc.).
There are many nuances to option vesting – most of which are of a regulatory nature and, to be honest, quite complex. However, it is vital that you understand the basic concepts outlined here. Take the time to understand and track the specific vesting details of any equity award you receive and, most of all, be sure to understand what effect leaving a firm may have on any awards that remain unvested. Don’t leave money on the table if you don’t have to!
