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.
Advantages & Disadvantages of Using a Vesting Schedule
Keeping Cash Available
After deciding to offer equity shares to employees, the usual procedure is to implement a vesting schedule. From a business owner’s standpoint, one major advantage of using a vesting schedule is that it lets the company have more cash available to use.
Since equity shares are a part of an employee’s overall compensation, less money needs to be used immediately to cover other forms of compensation, such as base salary, sign-on bonuses, or periodic performance-based bonuses throughout the year. This is a major reason why vesting schedules are a great idea for startups or growing businesses.
Saving Money and Retaining Employees
In the long run, a vesting schedule may save the business money. If an employee leaves the company before the vesting of his equity shares is complete, the unvested shares are forfeited and go back to the company. This winds up saving money on people who are not aligned with the long-term vision of the company. The shares that are given up can then be offered to better candidates.
Also, due to the nature of equity, a vesting schedule usually helps businesses keep great employees. Better employees want to stay and see their equity shares multiply in value while weaker employees, who probably lack the patience to stay at the company for a long period of time, are more likely to prefer shorter-term rewards.
While there are significant advantages of a vesting schedule, there are some disadvantages. Unfavourable or unreasonable vesting terms might drive great candidates away. Great talent may not necessarily want to join a company that has bad equity vesting terms. Make sure that your business’s vesting schedules are fair for both your company and your employees.
If the vesting schedule is too favourable for the employees, bad employees may hang around just long enough to become fully vested (costing the owner shares of the company) and then immediately quit once they receive the shares. This has a double-whammy effect, since the owner loses the shares and then needs to find replacement candidates quickly.
A vesting schedule forces a business owner to complicate the business’s long-term cash flow and financial planning. The accounting of all the shares, percentages, and vesting dates for each employee increases the complexity of the business’s financial books. Because of this, outside accounting and tax professionals must be hired to take care of this portion of the business, which increases costs.
Overall, the idea of vesting equity shares over time has its pros and cons for startups and small businesses. Each company is different, and the decision of whether to use vesting schedules to award equity shares should be made with guidance of an accounting or financial professional.