Shares Vesting (Meaning, Examples) | How it Works & Why it Matters?

Shares vesting refer to the grant of shares over a pre-decided tenure as the compensation package or contribution towards the pension scheme to the employees or to the founders of the company to reward them for their work performance and to retain them for longer years in the company.

Shares Vesting Meaning

Shares vesting means share awarded to employees or founders as a part of the compensation package or as a contribution to the pension plan and also as a way to reward and retain the individual. This shares by an individual is a process that happens over many years (usually four to five years).

Through share vesting, the company is able to keep its employees loyal to the company.
At the end of the share vesting period i.e. after four years the employee is able to acquire rights over the share or the contribution towards a pension plan that was made through the process of share vesting.
If the founder of the company is given shares for vesting, the terms of the agreement can be found in the ‘Shareholder agreement’ and if an employee has been offered shares for vesting, the terms are available under the ‘Employee contract’.

Examples of Shares Vesting

Suppose an employee receives shares to be vested over a period of four years. This means that a whole lot of this vesting in the company will only be available to the employee after four years. Hence, only after four years, the employee is said to be fully vested.

Let us say that Mrs. A is an employee of Company ABC. She receives an option to buy 1,000 shares of her employer who is Company ABC. However, these 1,000 shares cannot be vested in one go as they will need to be vested equally over a period of four to five years. Mrs. A will only be able to exercise her stock options after she is fully vested which is after four to five years.

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A classic example from the world of business which is often cited is that of an artist who worked on the office space for Facebook when it was only a year-old start-up company. Instead of receiving cash compensation for his work done for the interiors of the office space, the artist chose to take shares of Facebook and not his entitled cash compensation. When Facebook first went public with its initial public offering in the year 2012, the artist’s shares are said to be valued at around $200 million.

Advantages of Shares Vesting

Whenever a company offers shares vesting to its employees, it is very beneficial to the company. As it does not involve any cash payout, there is no outflow of cash on the company’s books. It simply means the company is offering the employee stock ownership of the company.
It is also very beneficial to employees as it puts them in the position of receiving high value for their shares, as we saw in the example of Facebook.
When companies include share vesting as a part of the employee contract, it leads to improvement in the performance of the employee. As the performance of the employee is tied to shares offered for vesting, the employee has an inherent incentive to perform well.
It also helps with employee retention. When employees know that there is a potential gain or reward in the form of shares vested in the future, the employee would rather stay in the company for a longer period of time than quite early on.
Further, when start-ups do their hiring, the salaries of employees are considerably low. By offering shares to be vested, the employees get additional benefits apart from their salary.

Disadvantages of Shares Vesting

Besides the many benefits of vesting in shares, one major disadvantage is that there are tax consequences. Depending on the types of shares that have been vested in, tax liability changes. Taxes may apply also depending on when you choose to buy and sell your share or stock option. Similarly, if a vesting share is given as a stock award, the income given as stock-based compensation for performance is liable to be taxed.
Another disadvantage is that the vesting by the employee is done on a long term basis. The benefit of vesting shares accrues to the employee only after four to five years i.e. once he is fully vested.
Recently hired employees may not receive the benefit of it as there exists a cliff period which will be discussed in the next section.
If the employee leaves the company or is fired before the time schedule of four-five years is completed, he or she is not able to avail of the complete benefits of this vesting.

Limitations

There is a concept of a cliff period that must be discussed here as a limitation of shares vested. A cliff period is a period when the employee is not allotted any shares of the company. This is usually a cooling-off period right after an employee joins a company. This period could range from a few months to one year. This cliff period must be completed and only after that employees are able to own shares for vesting. The cliff period exists so as to account for any risks that may arise during the initial few months or years of a start-up or when an employee is recently hired. These risks could involve a founder of the company quitting during the initial stages of the start-up or an employee who quits within the first few months.

Conclusion

It is a very beneficial instrument for both companies and employees. By incentivizing employees to perform better, the business interests of the company continue to stay alive. Employee retention is higher and so is their motivation to work towards the goals of the company. For the company, it allows for less hassle with hiring new employees as they stay for the long term due to the potential rewards through shares vested. It also safeguards the company’s shares as the existence of a cliff period does not allow early leavers of the company to benefit from them.