What is Vesting?
Vesting occurs when a financial instrument or account becomes wholly owned by an investor.
How Does Vesting Work?
For example, let's assume that John Doe receives options to buy 2,000 shares of Company XYZ, his employer, for $10 a share. He receives the options as part of his compensation package.
His shares vest over a five-year period, meaning they do not become exercisable for five years. This means John must stay at the company for at least five years before he can exercise his stock options.
Vesting is also common in retirement plans. For example, if John Doe's employer matches the contributions he makes to his retirement plan, those contributions might vest over, say, three years. This means that although the employer agrees to add extra, free money to John's retirement account, that free money doesn't really become his for three years.
Accelerated vesting occurs when a stock option becomes exercisable earlier than originally scheduled. So if Company ABC comes along and buys a 51% stake in Company XYZ, this constitutes a change in control and John Doe's options might automatically vest even though the five-year period has not elapsed. John exercises his options at $10 a share, sells the shares for $20 a share, and walks away with a tidy profit.
Why Does Vesting Matter?
Vesting is a tactic for encouraging loyalty among employees. Vesting can be a windfall to employees, though some tax consequences may exist. Depending on the type of option, for example, John Doe might need to pay taxes on the grant value of the shares ($10) as well as the capital gains on the profit from the sale of those shares.