Vesting refers to the right to earn a present or future payment, asset, or benefit. In most cases, vesting is determined by particular criteria agreed upon by both the current and future asset holders in a formal contract. Vesting is often offered as a way to grant benefits over time or with pre-agreed conditions.
In the context of an ESOP using call options, vesting is commonly referred to as the process of converting options so that they move from being unvested to vested.
Under an ESOP, the employee receives the option to purchase an agreed number of shares in the company. Through meeting agreed-upon criteria such as time employed by the company or reaching certain performance milestones, the employee will have their allocated options vest.
With vested share options, the employee isn’t receiving actual shares in the company just yet. What they’re getting instead is the right to buy shares from a date and at an agreed upon price. This date may be immediate or it could be a later date such as the point of a business sale or some form of liquidity event.
If options do not vest- for example, if KPIs or performance-based criteria aren’t met- then the options will lapse. Lapsed options will be allocated back into the ESOP option pool, where they can be granted again.
A vesting period in an ESOP is the time the employee holding the options must wait before they can exercise them for shares, and until the time the right to exercise them expires.
In many cases vesting does not occur all at once so specific portions of the options granted will vest on different dates over the duration of the period of the vesting. A vesting schedule is the criteria that specifies how vesting will occur, and is often captured in a table or chart showing the options that vest over time.
Common vesting schedules can be categorised into three types:
With time-based vesting you earn share options over time. This can be used for frequently repeated vesting events. The benefit of this type of vesting is that the incentive can remain at front-of-mind for employees. Using periodic vesting, the options vest gradually over a period of time, generally with a frequency of monthly, quarterly or yearly. For example, 10 share options vesting automatically every month for 48 months.
Alternatively, period vesting could be based on tenure or longevity with the company, which can be used to incentivise long term commitment from employees. For example, 100 share options vesting at the completion of every 12 months of employment over a 48 month period.
Another time-based method is to use a vesting cliff, where a certain number of options vest after an initial period has passed. This is often used to encourage new employees to stay with the company for at least a period of time before their allocated options are able to be exercised. For example, all 6 months worth of options only vesting 6 months from the start of the option plan grant.
This form can be used to vest options based on specific criteria yet to be met or achieved. This could be based on the successful outcome of a performance review or the meeting of a performance objectives or KPI, whether it is company, team or individual based.
For example, 200 share options vesting subject to the company ARR being greater than $1M by 01/01/2022.
ESOP schemes will often use a combination of both time-based and performance-based vesting, as this is a good way to balance employee performance and commitment to the company.
Vesting schedules can become complex, so here’s a basic example of a time-based schedule with a cliff for a new employee called Norman:
Norman’s ESOP Grant:
Grant date: January 1st 2020
Call Options granted: 240
Automatic vesting schedule: Monthly for 2 years with a 12-month cliff
Expiry date: December 31st 2025
One year after Norman’s grant date, on January 1st, 2021, he reaches his cliff and half of his shares (120 shares) vest, so he can now exercise those shares if he wishes (up until the expiry date).
Over the next year, an additional 10 options vest every month. By January 1st, 2022, Norman’s options are completely vested and he can exercise all 240 of the options granted if he chooses. If Norman leaves the company before January 1st, 2022, he will give-up any unvested options, which can be returned to the company’s option pool.
Once options have been vested then the employee can exercise and purchase them at the agreed price, usually in conjunction with a liquidity event or company exit. The options are realised as shares and the employee will become a formal shareholder.
Sign up for a free guided demo of Orchestra here.
DISCLAIMER: This article is for informational purposes only, and contains general information only. Orchestra is not, by means of this information, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests. Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor. This information is not intended as a recommendation, offer or solicitation for the purchase or sale of any options or shares.