Vesting Period: Everything You Need to Know
The vesting period is the period of time before shares in an employee stock option plan or benefits in a retirement plan are unconditionally owned by an employee.11 min read
What Is a Vesting Period?
The vesting period is the period of time before shares in an employee stock option plan or benefits in a retirement plan are unconditionally owned by an employee.
If that person's employment terminates before the end of the vesting period, the company can buy back the shares at the original price. The employee cannot sell or transfer the stock options during the vesting period.
The Tax Reform Act of 1986 established the minimum vesting rights for employees. Full vesting must occur within five years or at 20 percent vesting per year after three years of employment.
Vesting is the process by which an employee with a qualified retirement plan or stock option plan is entitled to the benefit of ownership. Once vesting occurs, the benefits of the plan or stock cannot be revoked. This is true even if the employee no longer works for the company, so long as the vesting period has been met.
A vested benefit is a financial incentive offered by an employer to an employee. Vesting helps employers to encourage employees to remain with the company for an extended period of time. Most vested benefits require employees to serve a number of years to acquire them, and the more years they work with the company, the more benefits they acquire.
A vested benefit can consist of stock shares or contributions to a retirement plan.
Vesting Within Retirement or Pension Plans
Vesting might occur through a qualified pension plan or a 401(k). The vesting period must use one of the standards set by the federal government.
Some benefits have no vesting period, meaning that the vesting is immediate. For example, employees are immediately vested in their salary deferral contributions to their retirement plan as well as employer contributions to an employee's SEP and SIMPLE accounts.
An employer's contributions to an employee's 401(k) plan may or may not have a vesting period. The traditional vesting plan for pensions is five years for cliff vesting and three to seven years for graded vesting.
Once fully vested, employees should know that it doesn't mean the funds are available for withdrawal. The withdrawal period will be defined by the rules of the plan. In general, funds cannot be withdrawn until the employee is of retirement age.
Types of Vesting Periods
There are different types of vesting and vesting periods. Each type has a certain vesting period during which employees must remain employed before they are the full owners of the benefits.
Graded vesting, also known as graduated vesting, is when an employee gradually becomes entitled to full benefits over several years.
Under a graded or graduated vesting plan, an employee might receive full ownership of 20 percent of their potential shares after two years. After three years, they receive 40 percent, after four years 60 percent, after five years 80 percent, and after six years they have 100 percent. After five years, the employee would be fully vested. If the employee leaves in year four, they still retain their vested benefits.
Cliff vesting is when an employee only becomes entitled to benefits once they're fully vested. If the vesting period isn't completed, the employee loses all of the employer-paid benefits.
For example, under a cliff vesting plan, an employee might gain 20 percent vesting benefit each year. But, if they leave the company before they work for five years and are fully vested, they lose everything.
An accelerated vesting offer might be made if a company makes an acquisition. What this means is that a company might offer their employees accelerated vesting of six or 12 months.
For example, if a company offered employees six months accelerated vesting after an acquisition, an employee who had worked there for two and a half years would now be vested for three years. The employee gains extra time on their vesting schedule.
The understanding behind accelerated vesting is that the employee didn't sign up to work for the acquired company and therefore should be rewarded for the change in environment.
The accelerated vesting is often only offered with a double trigger during an acquisition. This means that the employee might receive accelerated vesting after the acquisition, but only if they also are demoted or have a reduction in their duties.
The people most likely to be offered accelerated vesting are executives. This is because they are also the people most likely to lose their jobs in the event of an acquisition.
Fully vested means that the employee has earned the full amount of the offered benefit. Some plans, such as those that use cliff vesting, require that employees become fully vested to receive any of their benefits. If they don't become fully vested, they lose everything. On the other hand, with graduated vesting, an employee may leave the company and retain any vested benefit they have earned, even without becoming fully vested.
Accrual of vesting benefits is typically broken down by year, but that's not a requirement.
Vesting and Retirement Funds
Any money that you contribute to a retirement account that is from your paycheck is 100 percent yours. On the other hand, company matching funds typically vest over time. Until the match is fully vested, you cannot take the entire match with you. For some plans, you can take a portion of the matched funds with you before full vesting is reached; in others, you can take none of them.
Ask your benefits administrator for details of your employer's vesting schedule.
Beware of Unusual Vesting Requirements
There are common vesting requirements and then there are unusual ones. Vesting requirements have been examined, changed, and assessed for years. There are reasons and benefits to the usual vesting requirements.
This makes it all the more important to keep an eye out for odd or unusual vesting requirements. For example, in 2011, Skype was acquired by Silver Lake Partners. Buried in the acquisition agreement was a clause that required employees to be with the company at the time of sale or liquidation in order to have a right to their vested benefits. That means that employees who left after one and half years into the four-year vesting period received nothing when the company was bought by Microsoft because they were no longer employees when that happened. This is not how vesting is intended to work.
The more complicated the vesting structure, the harder it is for a company to recruit great talent. Employers must look at vesting from an employee's perspective. There's no motivation for an employee to join a company with a five-year vesting plan when the company next door has a four-year vesting plan.
Stock Vesting at Startups
The typical time period for an employee to become fully vested is four years. But why is that?
This typical scenario also requires a one-year cliff vestment. This means that if an employee doesn't remain with a company for at least one year, they receive no vesting. After one year, the employee receives a 25 percent vesting benefit. After four years, they have 100 percent vesting benefit, meaning they're fully vested.
Vesting may be acquired monthly, quarterly, or yearly depending on the vesting plan in place at the company.
The problem being discussed here is why the vesting period for startup companies is four years.
At venture capital firms, the vesting period is eight to ten years. If an employee of a venture capital firm leaves before eight to ten years, they forfeit part or all of their vested benefit. This makes sense for venture capital firms because it takes eight to ten years to manage an investment from initial to exit.
So, why doesn't the vesting period at a startup match the time from inception to exit of the startup?
The average time from inception to exit of a startup is six to eight years. In the beginning, in the 1990s this period was four to five years, which means that a vesting period of four years makes sense. That doesn't make sense today.
Once an employee is fully vested, which is typically after four years, they may come asking for more stock options during negotiations. Because of this issue, boards are finding that they must reissue stock options every three to four years because employees become fully vested.
Another option would be to make vesting schedules flexible and a part of the overall compensation negotiation. A CEO can benefit from having the ability to negotiate stock options and vesting periods when hiring.
For some companies, it might work out to offer six-year vesting periods in the beginning and then reduce the vesting period as new employees are brought on staff.
The question is why haven't these changes taken place in startup culture. Is there a reason that startup companies are sticking to the magic number of four?
Startup Founder Vesting
Not only employees can receive vesting from a company. Vesting can also be received by founders.
Vesting can be a way for founding partners to protect themselves against the other partner if the other partner chooses to walk away from the business after a period of time.
At the founding of a company, each founder gets a package of stocks. The founders often get a full package in the beginning to avoid capital gains and taxes. If one of the partners walks away after a period of time, the company will buy back that partner's equity in the business.
The standard vesting clauses will often apply even to founders. So there's typically a cliff vesting period of one year, where if the founder walks away before a year, they receive nothing. The remainder of the vesting period is usually graduated over four years.
If the company is acquired or purchased prior to founding partners being fully vested, there can be two acceleration options.
Single Trigger Acceleration
If your company gets acquired but you don't lose your job, you can accelerate your vesting by 25 to 100 percent.
Double Trigger Acceleration
This happens when your company gets acquired and you lose your job as a result.
When to Vest
Knowing when to vest with a startup can be complicated, but it's very important. Most founders include vesting clauses during the incorporation process or when raising funds during a financing round. You can also create a vesting clause whenever you and your partners feel that you've truly begun work on your company.
Importance of Vesting for Founders
Many founders are resistant to the idea of vesting. It might seem silly to founders, but the chances of a founder leaving a successful business and an employee leaving a successful business are vastly different. It's common for employees to leave a business before four years are out, but not for founders.
Because it's unlikely for a founder to leave, vesting becomes all the more important. Founders also typically get preferential vesting compared to regular employees.
Vesting and Exercising
Stock options and shares of stock aren't the same things. Stock options are a right, but not an obligation, to purchase stock at a specific time and a specific price.
Before you can purchase shares, also known as exercising your option, you need the option to purchase. As an employee you must earn the right to purchase those shares, and you need to become vested in those shares.
When you exercise your options, you become a shareholder in the company. Your investments become a vehicle for growth potential. There are guidelines to follow when exercising your right to stock options.
Exercising is the actual purchase of stock.
Stock option plans are designed to encourage employee ownership in a company. The theory behind employee ownership of a company is that when employees have a stake in the well-being of a company (stocks) they will make decisions that best benefit the company and will help it perform at its best. With stock options, employees become owners. Ownership of a company might also carry responsibilities such as voting.
Options are often treated like self-directed bonus plans. In this type of bonus plan, the bonus is tied to the value of the company.
It's also possible for employees flip their options. Within the same transaction, employees purchase shares and then immediately sell them.
After an Initial Public Offering (IPO), there's typically a period of time called the lockup. During a lockup, employees are restricted from exercising their stock option. The lockup period rules differ from company to company but is typically a period of 180 days (six months). After the lockup period, there may be some restriction, but there will be less. Your HR department will know how the rules of the lockup period apply to you.
Understand Your Vesting Benefits
Each company has a different plan when it comes to employee stock options. This means that it's important for employees to fully understand the stock options and plan. There are rules and tax implications that go along with every vesting benefits plan.
Some employers require that employees remain with the company for a certain period of time after exercising their option. Some employers only allow employees to retain stock while they're working for that employer. This helps to ensure employee loyalty and retention. Lose the employer, lose the stocks.
You can only exercise stock options that are vested. This means that you may be able to exercise on some of your stock, depending on how long you've been with the company. Different stock options may also be treated with different rules and regulations.
You should also realize that vesting is calculated on a per-grant basis. This is important if you receive certain options at different times during your employment. The options which vest earliest are the ones you originally received. The vesting of later options will depend on when you received them during your employment. If you leave before the latest vesting period, you won't receive the full benefits of that later vesting.
The most common method to exercise stock options is to pay cash. This is no longer the only option, but it is still the most common. Some employers have developed special arrangements with stockbrokers that allow payment alternatives for employees that don't require them to come up with a large lump sum of cash.
You may not only have to pay to exercise your stock option, but also to meet the withholding requirements. The amount of required withholding will be determined by the price of the stock purchased.
The rules and regulations for payment methods will be laid out in your plan's description, or you can ask your HR department for information.
Exercise the Option
Don't wait until the last minute to exercise your option. Waiting until stocks are about to expire before exercising is a bad idea because this can be a slow process. Give yourself ample time to understand what you're purchasing and the best time to make the purchase for you to benefit financially. These decisions can also determine the amount of your tax liability in the future.
You'll likely have to complete and submit paperwork to your employer prior to exercising your stocks.
What is a vesting period?
This is the period of time in which an employee doesn't unconditionally own his or her stock options or retirement benefits.
How long is a vesting period?
The vesting period depends on the company. Some companies have a vesting period of four years while others range from eight to ten years.
As an employee, what should I look for in a vesting period?
Shorter vesting periods are more beneficial to employees. Employees should also understand whether they're entering into a cliff vesting period or graduated vesting period.
- Do founders of a startup need to worry about vested benefits?
Yes! Vested benefits are also important for founders of startups. The stock options for vested benefits can help protect one partner from another.
If you're an employee of a company that offers vested benefits, or if you're interested in creating a startup company and need to lay out the vesting period and vesting benefits between you and your startup business partners, UpCounsel can help. You can also post your job on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers from UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Stripe, and Twilio.