Vesting is the process in which an employee gains ownership of employer provided benefits over a period of time. While there are varying vesting “schedules” that can be constructed, the general process remains the same. Read on to see why this is an important tool for small business owners to use, and see some example calculations.
Why Vesting is an Important Tool for Business Owners
Vesting is most commonly used for allocating profit sharing, stock options, and/or equity to employees over time. The primary reason vesting benefits business owners is that it encourages loyalty and keeps employees for longer periods of time. Instead of providing a lump sum of equity up front that allows the employee to quickly quit and walk away with, vesting allocates a portion of equity each year over a period of years. If an employee leaves before being 100% vested, they forfeit their unvested portion. Vesting encourages better employee to stay longer and weaker employees to leave sooner.
Types of Vesting
There are three basic types of vesting that small businesses and startups use:
- Immediate vesting — With this type, there is no schedule and the employee is 100% immediately vested. This is rare.
- Cliff vesting — Employees receive 100% of their equity or profit sharing all at one time, but after a stated period of years.
- Graded vesting — This is the most common. Employees receive a portion of their equity or profit sharing each year over a period of years until being 100% vested.
Example Equity Vesting Schedule
As an example of how equity vesting works, assume that a new employee negotiates to receive 2.5% equity in the company he starts working for. The contract stipulates a five year vesting schedule on this equity. Next, assume that vesting occurs on last day in April of each year.
This means that each year the employee will receive 0.5% equity which he is entitle to keep. The schedule would look as follows:
Year 1, April 30th – 0.5% equity allocated, 20% vestedYear 2, April 30th – 1.0% equity allocated, 40% vestedYear 3, April 30th – 1.5% equity allocated, 60% vestedYear 4, April 30th – 2.0% equity allocated, 80% vestedYear 5, April 30th – 2.5% equity allocated, 100% vested
Assume the employee quits the company on May 1st of the third year. He is entitle to keep 1.5% equity but the remaining 1.0% equity is forfeited back to the company equity pool.
Example Profit Sharing Vesting Schedule
A vesting schedule for profit sharing works the same way, but since different amounts can be added to the account each year, the numbers may be slightly more confusing. Assume a five year vesting schedule and employer deposits into the account each year are:
Year 1: $2,000Year 2: $4,000Year 3: $3,000Year 4: $5,000Year 5: $5,000
The percent vested, total account balance, and amount the employee is entitle to are:
Year 1: 20%, $2,000, $400Year 2: 40%, $6,000, $2,400Year 3: 60%, $9,000, $5,400Year 4: 80%, $14,000, $11,200Year 5: 100%, $19,000, $19,000