What is vesting?

Vesting refers to the right to earn a present or future 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.

Vesting in Employee Share Ownership Plans (ESOPs)

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 the 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 can be allocated back into the ESOP option pool, where they can be granted again.

Vesting schedules & structures

A vesting period in an ESOP is the time the employee holding the options must wait before they can exercise them for shares. The employee can then exercise them up until the specified expiry date.

In many cases, vesting does not occur all at once so specific portions of the options granted will vest on different dates over the vesting period. A vesting schedule is the criteria that specifies how vesting will occur, and is often summarised in a table or chart showing how the options vest over time.

Common vesting schedules can be categorised into three types:

Automatic/Time-based vesting:

With time-based vesting you earn share options over time. This can be used for frequently repeated vesting events, and the benefit of this type of vesting is that employees can receive regular reminders about the incentive. Using periodic vesting, the options vest gradually over a period of time, generally with a monthly, quarterly or annual frequency. For example, 10 share options vesting automatically every month for 48 months.

Alternatively, periodic 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, 6 months worth of options not vesting until 6 months after the start of the option plan.

Manual/Performance-based vesting:

This schedule can be used to vest options based on specific criteria yet to be met or achieved. This could be based on the meeting of performance objectives or KPIs, whether it is company, team or individual based.

For example, 200 share options vesting subject to the company Annual Recurring Revenue being greater than $1M by 01/01/2025.

Hybrid vesting:

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.

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Different vesting schedules and which ones to use?

Vesting schedules for options are designed to provide an incentive for employee share scheme participants. By making the options they receive subject to a period of time or performance milestones, a company can incentivise staff to stay with the company for a period of time and commit to building success. It also means that if an employee does leave the business during the vesting period, they do not take shares with them that they have not yet earned.

However it is a fine balance to get these incentives right, as the wrong vesting structures could unintentionally impact employee engagement or staff perception of the ESOP plan. Traditionally, ESOP vesting schedules for participants have often been 4 or 5 years with a one-year cliff, however high competition for talent and demands for flexibility has resulted in changes, particularly for technology companies.

For example in 2021, Google introduced a model in which two-thirds of the equity granted to employees vested in the first two years of employment, while Lyft and Stripe implemented models in which all equity vested in the first year. Australian and New Zealand companies appear to be in a good position to already meet these demands compared to North American companies. Shorter vesting schedules are more common in Australia and New Zealand with the majority being 4 years or less.

Balancing vesting structures to provide the right short-term and longer term incentives, can also avoid a Silicon Valley phenomenon known as "rest and vest." This is where employees may be coasting along in a job they dislike just to wait for their options to vest!

An advantage of having a vesting schedule like periodic vesting with a monthly or quarterly frequency is that it gives an opportunity to regularly communicate with employees on their ESOP, which leads to greater participation and engagement. This doesn’t necessarily mean more work for the company as ESOP management software like Orchestra can automatically send email updates to employees when their options have vested, encouraging them to log-on to view their details and keeping their ESOP incentive top-of-mind.

An example of a vesting schedule

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).

Vesting schedule Year 2

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.

What happens after vesting?

Once options have vested then the employee can exercise them at the agreed price. The options are realised as shares and the employee will become a formal shareholder.

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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.