What It Is And How It Works

STOCK TRADING ALERTS


Some employers offer equity or stock options as part of your compensation. It’s a widely used tool for startup companies. With that comes a whole host of new terms you need to understand. One of the areas that are important to understand in stock option plans is Stock Option Vesting.

When you get equity offered, you are really offered part ownership in the company in the form of company shares. But you usually don’t get that ownership immediately when you join the company. You will need to work for some time to access that equity.

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In my career, I’ve been offered common stock options several times for the years of service I provided for different companies. I’ve gone through the process of getting a stock option agreement, vesting stock options, and exercising them in the case of ISO stocks. Because of this, I have first-hand experience with the process and know what to look for when dealing with stock options. I’ve also been fortunate enough to experience an IPO myself and navigate everything that comes with such an event in connection to stock options.


Key Takeaways

  • Vesting gradually unlocks the stocks or stock options
  • 4-year vesting schedule with 1-year cliff is the most common
  • NSO/ISO vesting gives you the right to purchase stocks
  • RSU vesting gives you the stock without having to pay

What Does Vesting Mean?

General description of earning the underlying asset. You can only buy what’s vested.

The stock options you are offered are not yours immediately. Before they are, they need to “vest”. It simply means that it will take time for you to earn the ownership right of your assets. It is important to understand that you can only buy your vested stock options.

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Vesting With Stock Options – NSOs and ISOs

You unlock the right to purchase stock at a discounted/predefined price

If you have been offered NSOs (Non-Qualified Stock options) or ISOs (Incentive Stock Options), vesting them means unlocking the right to purchase or exercise these stock options. So, you are not unlocking the actual stock. You just get the right to buy them yourself.

When you signed your Stock Option Agreement, you agreed to a predetermined price for exercising your stock options. This is the price you will pay for each stock you exercise.

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This process is the same for NSOs or ISOs.

Regarding taxes, vesting NSOs and ISOs of company stock does not create a taxable event. You will only create a taxable event if you buy the vested stock options. The amount of taxes will depend on the fair market value (aka current share price), your strike price (the price you will pay per share, aka exercise price), and the time since you signed your employee stock option plan.

Do you want to know more details about ISOs, NSOs, taxes, exercising employee stock options, and alternative minimum tax? Head over to my article “How Are Employee Stock Options Taxed: ISO vs. NSO“.

Vesting With Stock – RSUs

RSUs (aka Restricted Stock Units) differ slightly from NSOs or ISOs. With RSUs, vesting actually means getting the stock itself immediately. So, with RSUs, you will not have to buy the stocks. Instead, you will get them automatically as a stock grant.

This distinction is important since vesting RSUs will create an immediate tax burden. You will have to pay ordinary income tax on your RSUs.

If you hold onto them and let them grow, you will also have to pay capital gains taxes on the capital gain once you sell them at a higher price.  Sometimes, your employer withholds some RSUs to cover your taxes. In other instances, he might allow you to pay the taxes with cash. This option will enable you to hold onto more stock units.

To read more about RSUs and taxes, click here.

What Is A Vesting Schedule?

First of all, there are different types of vesting schedules. The most common one is a time-based vesting schedule. Sometimes, your vesting schedule can also be tied to your performance.

Time-Based Vesting Schedule

With a time-based vesting schedule, your stock options or stocks will vest solely based on time. The most widely used vesting schedule for a time-based vesting period is the 4-year vesting schedule with a 1-year cliff (aka cliff vesting).

In this vesting schedule, 25% of your stock option grant or stock grant unlocks after a waiting period of one year since you signed the stock option agreement. After that first year, the rest of your assets unlock gradually over 36 months.

Let’s take a look at an example:

You sign a stock option agreement with a 4-year vesting schedule and a one-year cliff. Your agreement grants you 2400 stock options.

600 of these stock options (or 25%) unlock after 1 year. The remaining 1800 stock options are divided into 36 equal parts of 50 stock options. So each month after that 1-year cliff, 50 stock options will unlock for you for 36 months in total. After 4 years, you have unlocked 2400 stock options. In other words, you have fully vested all of your stock options.

To visualize that, take a look at the following chart:

Time-based stock option vesting schedule over 4 years with a 1 year cliff.

Another way to visualize the vesting of your employee stock option plan:

Date What Happens?
1/1/2023 Signed Stock option Agreement with 2400 Stock Options
1/1/2024 600 vest (25%)
2/1/2024 50 vest (1/36th)
3/1/2024 50 vest (1/36th)
1/1/2027 50 vest (1/36th)

Not all time-based vesting schedules use cliff vesting. Sometimes, they immediately start vesting on a month-to-month basis. Imagine you already work for 10 years at your company. Because of your excellent work, your employer offers you some stock options. At this point, the employer does not have to fear that you will leave the company immediately. He knows what you can do already from your past performance.

Performance-Based Vesting Schedule

Sometimes, the vesting of your stock options or stocks is tied to your performance on the job. This means that they will only vest when you are reaching an important milestone or release a product. This type of vesting schedule is also called milestone-based vesting.

These vesting schedules can vary greatly depending on the individual company offering them. There can also be defined deadlines or expiration dates.

Performance-based vesting schedules are a common tool to incentivize a company’s leadership team to stay with the company and drive the business forward.

Do Employee Stock Options Expire?

If you look closely at your Stock Option Plan or Agreement, you will probably find an expiration date.

This expiration date defines the time frame for exercising your vested stock options. If you fail to exercise your stock options, they will become unavailable.

Although individual agreements vary, the most common expiration date is 10 years after the stock option grant date. This leaves you with more than enough time to exercise your stock options.

But what happens if an employee leaves his job? Typically, you will get a 90-day time window to exercise any stock options vested until your last day at work. After leaving your company, no additional stock options will vest. By leaving, you have given up the right to gain access to the unvested shares.

My Company Is Private – Can I Sell My Stocks?

It is very common for private companies in their start-up phase to offer stock options to their early employees. Because these companies are private, you cannot trade their stock in the open market.

However, the company can decide at any point in time to offer a stock buyback. This event can allow you to convert some or all of your acquired stocks into cash.

Another option is a liquidity event, such as an acquisition, merger, or an IPO (initial public offering). How much of your stock you can cash out in a merger or acquisition depends on the deal.

In the event of an IPO, you will be able to trade your stocks on the stock market. There are some limitations that apply to you as an insider of the company though.

Final Thoughts – Stock Option Vesting: What It Is And How It Works

Employee stock option plans can be difficult to wrap your head around. There is so much financial lingo in that topic, which can make it very hard to fully understand.

Knowing what you can expect from your ISOs, NSOs, or RSUs is important for many reasons. Understanding the typical vesting schedule and vesting terms is a good first step to educating yourself.

But you should not stop there because there is so much more to know about this topic! Your tax liability is the most important aspect to understand when the time comes when you want to exercise your stock options or get your RSUs. Making any mistakes with that can be very costly and have a significant impact on your finances. I recommend reading my article “How Are Employee Stock Options Taxed: ISO vs. NSO” as your next step. You can learn more about the tax implications when exercising stocks.

Disclaimer: The information in this blog post should not be considered tax advice, financial advice, or a replacement thereof. They are solely provided for informational purposes.

You should talk to a financial advisor and tax professional if your tax situation becomes more complex. Finding a good financial advisor is not easy. I recommend the Garrett Planning Network, the National Association of Personal Financial Advisors (NAPFA), and the XY Planning Network. These networks can get you in contact with a fee-only advisor. No matter how much money we are talking about, it will not change your costs.



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STOCK TRADING ALERTS