How does share vesting work?
While equity allocation to employees can be highly beneficial to the workforce, founders have often wondered what happens if the potential top-tier employees leave the company too soon. This is exactly why you need to make visible terms and conditions before offering partial ownership to your workers.
A company usually allows its working candidates the right to employ stock options like the Non-qualified Stock Options (NSO), Incentive Stock Options (ISO), or Restricted Stock Units (RSU).
The risks involved with the offers in the case of the employers are not often talked about. To mitigate these risks, share vesting is an effective remedy to these concerns.
What is Share vesting?
Share vesting is the process of allocating shares to employees with a time limitation. The employees may be required to either wait patiently until an expected period of time or hit certain targets as expected by the company to acquire full ownership over the delegated shares. The constraint in gaining the power to claim their shares varies according to the vesting schedule. Most companies follow a standard vesting schedule of 3–4 years.
For example, Sarah from ABC company is allotted 500 shares with a four-year vesting period and a one-year cliff. After completing one year of service in the organization, she receives the right to exercise 125 shares with every advancing year. Also, if she quits in the third year, 250 of her shares will be fully vested. When she leaves the company, she surrenders the 250 unvested shares back to her company.
Why is share vesting crucial for a company?
Firstly, the ownership that comes with the right to stock options, makes the employees believe that their contribution is vital to the business operation. They feel responsible enough to serve the vesting period, offering more meaningful services to the company which is a simple yet effective investment strategy from the employer’s perspective.
Share vesting ensures a long-term commitment from the employees since only after the vesting period can they exercise complete power over the shares. Though longer vesting schedules than the recommended 4-year time frame may backfire, it is a key factor in retaining appreciable skills in the company. As a result, the company’s value increases with the extended serving years.
Most importantly, share vesting shields the company from running out of funds when the employees choose to quit halfway.
Employees who are fully vested can remain, partial owners, even after they quit. This can cause issues in equity management. Therefore, investing time in formulating vesting schedules is very important.
How does share vesting work?
Your employer allows a certain number of shares with a vesting schedule and cliff as per your employment contract. You then work to serve the cliff period and leverage the assigned number of shares gradually. This can be done depending on the type of vesting schedules your company offers.
1. Time-based vesting
Time-based vesting is the process where your company insists you wait for a given period of time after which you gain complete ownership over the shares allotted to you.
For instance, your service in the company begins in 2022. Your company allows you shares with a vesting period of 3 years and a one-year cliff. You cannot exercise your right over them until 2023- your cliff period. After this, you will gain complete access to these shares by 2026 (after 3 years of vesting time).
2 . Milestone-based vesting
Certain employers set a few tasks you should complete or targets you need to hit before gaining access to your shares. This is called milestone-based vesting. For example, you are an app developer, and your company may set a productivity scale to gauge your yearly performance, say an 80% productivity for the quarter, after which you can have 5% access to your shares. After hitting your productivity target in the next quarter you will gain 10% access to your shares and the access keeps expanding gradually.
3. Hybrid vesting
A hybrid vesting schedule works in scenarios where employers require you to serve both time-based and milestone-based vesting periods. You might have to accomplish the said number of tasks in the stipulated time period to enjoy complete exercise over your shares.
Consider Jacob being reserved 1000 shares in XYZ company with a vesting schedule of 4 years in January 2020. The company puts him on a one-year cliff over his schedule. That means he has zero shares to exercise his right, until Jan 2021. If he quits by July 2020, he will receive no shares. Assuming Jacob wants to serve until Jan 2021, he receives 250 shares when he leaves. If he serves until Feb 2022, he receives 500 shares options.
Let us say, Jacob resigns after Jun 2023, he gets access to 625 shares considering all the previous year’s share reservations, and is obliged to submit the remaining 375 unvested shares to the company. Also, Jacob’s shares become fully vested if he wishes to serve XYZ forever.
Summing up
Share vesting can be an exhaustive task to design for employers as it involves many factors to consider. You must keep track of your findings, investments, and the potential of your employees to offer a fair equity policy. Eqvista has years of experience in drafting share policies and financial consultations. You can talk to our expert executives to analyze what ESOP plan or share vesting schedules suit the best for your company. Book your first consultation call here to resolve all your queries.
