Vesting of option: Overview, definition, and example
What is vesting of option?
Vesting of an option refers to the process by which an individual (usually an employee, shareholder, or option holder) gains full ownership or the right to exercise their options (such as stock options or options to purchase company shares) after meeting certain conditions, typically over a period of time. The vesting schedule dictates how long the person must wait before they can fully exercise their options. Vesting often depends on factors such as the individual’s length of employment, meeting performance milestones, or a specific time frame outlined in the option agreement. Once the option vests, the holder has the right to exercise it, meaning they can purchase the underlying asset or shares according to the option terms.
For example, a stock option might vest over a period of four years, with 25% of the options vesting at the end of each year. After four years, the employee would have full access to the stock options.
Why is vesting of option important?
Vesting of options is important because it provides both the employee and the employer with incentives to maintain a long-term relationship. For employees, it creates the motivation to stay with the company and meet the performance requirements to fully benefit from their options. For employers, vesting ensures that the employee does not immediately take full advantage of the options, promoting loyalty and aligning the interests of the employee with the long-term success of the company. It also serves as a tool for employee retention, as options that haven’t vested can be forfeited if the employee leaves the company prematurely.
For businesses, vesting options provide a structured way to reward employees for their time and contributions. For employees, vesting provides a potential financial reward tied to the company’s success and their own commitment to the organization.
Understanding vesting of option through an example
Imagine an employee is granted stock options by their company as part of their compensation package. The stock options are subject to a four-year vesting schedule, with 25% of the options vesting at the end of each year. After one year of employment, the employee would have the right to exercise 25% of the total options. After two years, 50% would be vested, and so on. By the end of four years, the employee would be able to exercise all of the stock options, assuming they remain with the company and meet the vesting conditions.
In another example, an entrepreneur may offer options to key employees in a startup. The employees’ stock options may vest over three years with certain milestones, such as securing funding or reaching a revenue target. Once these milestones are met and the time passes, the employees can fully exercise their options to buy shares in the company at a set price.
An example of a "vesting of option" clause
Here’s how a vesting of option clause might appear in a stock option agreement:
“The Option granted hereunder shall vest in four equal annual installments of 25% each, beginning on the first anniversary of the Grant Date, subject to the Option Holder’s continued employment with the Company. Upon the completion of each year of service, 25% of the total Option grant shall become exercisable. Unvested options shall be forfeited upon termination of employment.”
Conclusion
Vesting of options is a key concept in stock options and compensation packages, ensuring that employees or stakeholders earn the right to exercise their options gradually, based on the passage of time or the achievement of specific milestones. This mechanism helps retain talent and aligns employee interests with the long-term success of the company. Whether in the form of stock options, retirement benefits, or other financial instruments, vesting provides an incentive for individuals to stay with the company and contribute to its success over time.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.