A vesting schedule is an incentive program established by an employer to give employees the right to certain asset classes. Employers use such type of incentive to reward loyal employees who remain with the company for a long period.
A vesting schedule gives employees full ownership rights to employer-provided assets over time. For example, a vesting schedule for pension plans is set up in a way that determines the specific period after which a beneficiary acquires full ownership rights to the assets.
It is also used to allocate profits, equity, and stock options to employees. Employees forfeit their unvested portion of assets if they leave before being 100% vested. Exclusive ownership rights accrue depending on the length of an employee’s contract.
A vesting schedule is an incentive program that, when fully acquired, gives an employee lump sum benefits of stock options.
A vesting schedule allows an employer to reward employees who stay longer with the company and penalize employees who terminate their contracts early on.
Non-forfeitable rights accumulate according to an employee’s contract period.
How Vesting Schedules Work
A typical vesting schedule is seen when employees are awarded money through a 401(k) company match. In such a case, it takes years to match dollars, implying that employees must prolong their stay with the company to be eligible for full ownership rights.
The primary reason that a vesting schedule is beneficial to business owners is that it is a valuable employee-retention strategy, which encourages high-performing employees to stay longer and non-performing employees to leave sooner. Take, for example, where an employer offers an employee 100 restricted stock units as part of the shared profit. For an employee who chooses to stay longer, say for five years in a company, the stock vests in line with the following schedule:
From the table, if an employee decides to leave in the third year, only 50 units will be vested, while the remaining 50 will be forfeited. Vesting is immediate for some benefit plans. It can be well-illustrated in the case of a retirement plan, where employee salary-deferral contributions are always 100% vested. The pattern can also be seen in the SEP and SIMPLE employer contributions. Employees can realize immediate vesting in their employer-contributed 401(k) plan.
Alternatively, the contributions may use either a cliff vesting schedule or a graded vesting schedule to vest immediately. In the former scenario, an employee is given 100% ownership rights to the contributions after a certain period. In the latter scenario, employees are entitled to yearly ownership of their employer’s contribution.
A graded vesting schedule of between three to seven years and five-year plan vesting schedules are commonly used in traditional pension plans. Employees cannot withdraw vested money anytime they want because they are fully vested in their employer’s contributions plan. They are still required to reach retirement age before executing penalty-free withdrawals, in line with the plan’s rules.
Types of Vesting Schedules
1. Milestone-Based Vesting
Milestone-based vesting refers to a vesting method where stock options and benefits are granted to employees based on the achievement and performance of certain milestones in a company.
For example, employees in the sales and marketing unit of a company may be granted stock options after attaining a specific objective. Similarly, accountants employed in an accounting company may be given stock options following the completion of a certain number of monthly audits.
2. Time-Based Vesting
In a time-based vesting schedule, employees earn their percentage of stock options over time according to a cliff or schedule. A cliff is a time when the first option of an employee is granted. The rest of the options are granted quarterly or monthly, in line with a vesting schedule.
3. Hybrid Vesting
Hybrid vesting is a combination of milestone-based and time-based vesting. It dictates that employees are only eligible to exercise stock options after staying in a company for a certain period and attaining a particular objective.
Vesting Schedule Special Considerations
The common form of vesting in wills and bequests often assume a waiting period to claim the rights to inherit following an heir’s demise. The waiting period is used to settle emerging conflicts and reduce the chances of double taxation in the case of two or more testators dying.
For example, a vesting schedule can be used to determine the entitlement of a minor’s shares. In such a case, special provisions are applied so that a minor’s share will not be vested 100% before reaching 18 years of age or getting married. If the minor dies, he/she forfeits the rights to inherit, and his/her shares are distributed among other beneficiaries. The shares can be vested immediately upon which there are no interests.
Startups usually provide grants of access or common stock to stock option plans as a form of compensation. The grants can target employees, vendors, executive members, or service providers to promote loyalty and encourage productivity towards a company’s goals and objectives. Such forms of grants cannot be sold during the vesting period because of the plan’s rules.