Vesting & Equity Compensation: What Execs Must Know

Key Points:

• Vesting of Equity Instruments: A crucial process for earning rights to equity compensation.
• Types of Vesting Schedules: Time-based vesting is commonly used but it can be based on performance.
• Key Terms: Understanding key terms like grant date and vesting schedule is crucial for executives to comprehend the details of their equity compensation.
• Advantages of vesting for the company include fostering retention, aligning performance goals, mitigating risks, and ensuring governance compliance.
• Disadvantages of vesting for executives can include illiquidity, potential performance disconnect, and limited career flexibility due to prolonged commitment.

Introduction

I know, you want to jump right into the juicy compensation tools but before we explore the details associated with each type of compensation component, it is important to understand the vesting of equity instruments first and it’s impact on equity compensation. It affects almost every component other than base compensation and cash bonuses.

Vesting refers to the process by which an individual earns the right to equity compensation over a specified period or by achieving predetermined performance milestones. Rather than receiving equity outright, vesting ensures that executives meet certain criteria or remain with the company for a specific duration before obtaining full ownership of their allotted shares or options. It is extremely important to understand the concept of vesting before reviewing the details of any compensation tool, as vesting is usually an integral part of the compensation process.

The complexity and type of vesting are only limited by a company’s imagination (and their lawyers), but time-based vesting is a commonly used mechanism where vesting occurs over a specific period. One of my previous employers used a “cliff” vesting schedule where none of the shares vested until 3 years after the grant, at which point the entire grant vested at once. Alternatively, a more common example is vesting equally over several years.

Terms & Example

Award

The term “award” refers to the grant of a specific type of equity interest in a company, usually shares, to an employee, executive, or other stakeholder as part of their compensation package.

Grant Date

The grant date is the contractual date on which compensation shares/amount/item were awarded to the employee. However, this could be several days or weeks later than when the executive was informed about the compensation. Be sure to read the award letter to determine the actual grant date.

Vesting Date

The “vesting date” is the date on which an individual becomes fully entitled to a particular asset, most commonly shares or options granted as part of an equity compensation package. On this date, the asset “vests,” meaning it is no longer subject to forfeiture, and the individual gains full ownership rights. If the award vests over a period of years, the dates for each amount will usually not be stated, instead you need to calculate it using the vesting schedule.

Vesting Schedule

This is the process by which the employee gains ownership of the compensation. It usually comes in two main forms:

• Cliff vesting means that employees earn all their equity compensation at once after reaching a certain time period.
• Pro rata vesting means that employees earn their equity compensation gradually over time.

Again, it is important to read the award letter and agreement because vesting terms are only limited by a company’s island lawyer’s imagination.

For example, let’s consider a scenario where a company grants an executive 1,000 shares, with 25% vesting each year over the next four years (this form of grant is called Restricted Stock Units (RSUs)). When this pattern continues for several consecutive years, with the vesting percentage increasing each year based on company or executive performance, the executive’s vesting schedule may begin to take the following form:

The depicted schedule highlights the accumulation of share vesting, particularly in years where multiple grants with a substantial vesting portion occur simultaneously.

It’s important to note that this example provided is for illustrative purposes only, and actual vesting schedules can vary significantly depending on the company’s discretion and the terms of the grants. Executives should carefully review the terms of their agreements and consult with their company’s HR or stock plan administration team to understand the specific details of their vesting schedule.

Advantages & Disadvantages

While this section primarily focuses on the executive’s perspective, it is crucial to recognize that all compensation structures are primarily designed to align with the goals and interests of the company. Therefore, it is important to note that many of the advantages associated with vesting ultimately benefit the employer. By implementing vesting schedules, the employer can foster executive retention, enhance performance alignment, mitigate risks, and ensure adherence to governance principles, thereby promoting the overall success and growth of the organization.

Advantages of Vesting

1. Retention: Vesting schedules incentivize executives to stay with the company for a specified period, promoting stability and continuity within the leadership team.
2. Performance Alignment: By tying equity compensation to predetermined performance targets, vesting encourages executives to focus on long-term goals and maximize shareholder value.
3. Risk Mitigation: Vesting mitigates the risk of premature or undeserved equity distributions, reducing the potential for dilution or a negative impact on the company’s stock price.
4. Governance and Compliance: Vesting promotes transparency, fairness, and adherence to corporate governance principles, ensuring executives are aligned with shareholders’ interests.

Disadvantages of Vesting

1. Illiquidity: During the vesting period, executives may not have immediate access to the full value of their equity compensation, which can restrict their ability to realize its financial benefits.
2. Performance Disconnect: In some cases, executives may view vesting as a guaranteed reward and become less motivated to perform once they have secured their vested shares.
3. Opportunity Cost: Executives who remain committed to a company for the entire vesting period may miss out on potential opportunities elsewhere, limiting their career flexibility.
4. As these grants persist over numerous years, viewing this portion of your income as anything other than regular earnings can become challenging. Consequently, it may pose difficulties in disengaging from such compensation, giving rise to a phenomenon commonly referred to as “Golden Handcuffs.” We will delve into the Golden Handcuffs concept later, exploring its implications and potential challenges.

Other Restrictions

Vesting is by far the most common restriction placed on equity compensation, but it is not the only one. As your career advances, you may have additional restrictions placed on you as a top leader in the organization. Some of those restrictions include:

Blackout Periods: A blackout period is a specific time frame when employees and other insiders are prohibited from buying or selling shares in the company. They are imposed to prevent insider trading, usually before the release of significant new releases or financial information, such as quarterly earnings reports.

Rule 144 Stock: Rule 144 is a regulation enforced by the U.S. Securities and Exchange Commission (SEC) providing guidelines for the sale of “restricted” or “controlled” securities. Restricted securities are typically acquired in unregistered, private sales from the issuing company or from an affiliate of the issuer. Rule 144 allows for the resale of these shares if certain conditions are met, including a holding period, availability of public information about the issuer, and the manner of sale, among others.

Rule 701 Stock: Another SEC regulation, but it focuses on equity compensation plans. It provides an exemption for private companies from registering securities offered as part of written compensation agreements to employees, directors, general partners, trustees, or consultants. Rule 701 is often used by startups and other private companies to issue stock options or other forms of equity to employees without going through the complex registration process with the SEC.

Lockup Periods: A lockup period is a predetermined amount of time following an initial public offering (IPO) during which insiders and early investors are prohibited from selling their shares. The purpose of a lockup period is to stabilize the stock price post-IPO by preventing a flood of shares from hitting the market too soon.

If any of these additional restrictions apply to your equity, your company will inform you of the restrictions and explain the applicable periods.

Conclusion

Understanding vesting is essential for corporate executives as it directly impacts their equity compensation. Vesting ensures executives meet specific criteria or remain with the company for a designated period before gaining full ownership of their equity. It brings the employer advantages such as retention, performance alignment, risk mitigation, and governance compliance. However, vesting also has disadvantages for the executive, including illiquidity, potential performance disconnect, and opportunity cost. By comprehending the intricacies of vesting, executives can make informed decisions regarding their equity compensation and contribute to the company’s long-term success.

Ready to take control of your financial future? Contact Purpose Built today to develop a tailored strategy that maximizes your executive compensation and sets you on the path to financial independence. With expert advice and personalized solutions, we help you turn every dollar earned into a stepping stone towards your long-term goals. Reach out now to schedule a consultation.

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