Updated July 19, 2023
Definition of Share Vesting
Share vesting can be defined as an agreement entered by a corporate body and its investors, shareholders, employees, or co-founders whereby the agreed party is provided the company’s stock after a pre-decided period of time or after the fulfillment of agreed terms as a part of the compensation or maybe a contribution to the pension scheme for its employees or co-founders of the company to reward them for their performance and/ or to retain for longer period of time.
Explanation
Vesting of shares implies that the counterparty will get entitled to shareholding rights of shares over a period of time by providing agreed services to the company. Share vesting means rewarding shares to the founders, employees, and owners as a part of compensation or retirement benefits. It is also a way to award and retain the employee. This process is usually a long-term process and maybe range from four to five years. Share vesting helps a corporate body to ensure employee loyalty towards the company. Share vesting terms and conditions may be defined under the shareholder’s agreement in the case of the founder of the company, whereas, in the case of employees, vesting terms are defined in the employee contract/ policies. If an employee quits the organization and has vested shares, then the organization may have the option to repurchase the shares at the original issue price, that is, par value.
Example of Share Vesting
Following are the examples are given below:
Example #1
Many employees have been working in a company for more than 20 years, and now the company has decided to reward them for their loyalty to the company. In such a situation, the company can offer them its shares with a share vesting plan. Accordingly, a vesting plan of four years was created to offer 1000 shares of the company to such employees. Such shares will be vested completely after a period of four years, and a cliff of one year was also added. There was one more ruler added, known as after cliff, which states that the next percentage of shares which will be awarded after the first part has been issued. Similarly, the remaining shares will be awarded the same until the vesting period ends.
The employee will get 25 percent of the total shares at the end of year one, with a vesting period of four years and one year of cliff time. The company can set the rule that the employee cannot sell the shares until the vesting period is over. This will help the company secure its assets i.e. the employee, by rewarding him and making him stay longer. If the employee leaves before all the shares are vested, the company has a right to take back all the shares in the company’s account.
This can be understood better by the following chart-
|
Time |
Percentage of Vested Shares |
| Start of The Vesting | 0 |
| At the End of Year One | 25 |
| At the End of Year Two | 50 |
| At the End of Year Three | 75 |
| At the End of Year Four | 100 |
Example #2
Amazon Inc. hired Sam on 01 January 2019. his salary package includes a vesting plan for four years for 240 shares of amazon inc. the plan was granted on 01 January 2019 with monthly 5 shares with a one-year cliff. Here the cliff year will end on 01 January 2020, and Sam will be given 60 shares (25% of total shares i.e. 240 shares). He can exercise his rights over these 60 shares.
|
Date |
Option Vested |
| 01 January 2020 | 60 |
| 01 February 2020 | 5 |
| 01 March 2020 | 5 |
| 01 April 2020 | 5 |
| 01 May 2020 | 5 |
| 01 June 2020 | 5 |
So On, till the completion of the entire vesting period.
Share Vesting Tax Treatment
Share vesting is taxed differently than any other stock option, like an employee stock purchase plan; these plans are generally taxed at the time of the exercise of sale. Still, the vesting shares become taxable on completion of the vesting period. for vesting, the complete amount of vested stock forms part of the total income in the year of vesting.
The amount that needs to be declared as income is determined by deducting the exercise price or the purchase price of the stock from a fair market value of a stock as of the date when the stock is fully vested. The difference between the two must be reported as ordinary income by the shareholder. But if the stock is not sold by the shareholder at vesting and is sold later, then the difference between the sale price and fair market value on the date of vesting must be recorded as a capital gain.
If a person elects section 83(b), he is allowed to report the fair market value of the shares as ordinary income as on the date when they are granted in place of the date when they become vested. The stockholder will still be liable for capital gain rules but from the grant date. The selection of this section can lower the taxes that need to be paid as the stock price is much lower at the time of grant than when it is vested. this section is very helpful in cases where there exists a long interval gap between the grant of shares and their time of being vested.
Share Option vs Share Vesting
Share vesting and share option are both forms of equity compensation but have different conditions and characteristics. Vested shares are rewards and compensations completely to the founders and employees for their loyalty towards the business and have the same rights and privileges as of a shareholder i.e. They will receive dividends and can vote in the annual meetings. but the company has all rights to take back unvested shares if the employee leaves the job before the vesting period ends. While stock options are the right o buy a certain number of shares at a fixed price on a future date. It benefits the owner only if the stock market price increases and exceeds the option purchase price.
Advantages
Some of the advantages are given below:
- It does not involve any cash outflow, forming an important reward for both parties. no money flows out from the books of the company. It is only a company offering ownership to its employees.
- It is also very advantageous for the employees as the company grants them a position to receive high-value shares.
- Employee contract, including a share vesting clause, leads to the improvement of the overall performance of the employee.
- Share vesting leads to employee retention. when there is a potential gain or reward in the future in the form of shares vested, the employee will work hard and stay in the company for longer periods without quitting the job.
- It is very helpful for startups as initially they cannot provide high salaries but can give vesting of shares as compensation to attract the employee.
Disadvantages
Some of the disadvantages are given below:
- Employees perform the vesting of shares on a long-term basis. the actual vesting benefit will occur only to employees retained during the entire vesting period.
- Tax is the most disadvantageous factor for vesting of shares. tax liability will vary in different types of shares that are vested. taxes will be levied on choosing the date of purchase and sale of stock options. rewards earned in the form of shares vested will incur an income tax liability.
- If an employee leaves the job or is terminated from the job, he may not avail full benefits of vesting.
Conclusion
It can be defined as an agreement between a company and its investors, co-founders, and employees to grant its shares after the fulfillment of a certain time period or on the fulfillment of agreed terms and conditions. This vesting helps to ensure long-term relations between agreed parties and tends to increase loyalty towards the company. even it benefits the company as it does not involve cash outflow. Employees are taxed for such rewards and, therefore, may sometimes find it less attractive if in case a non-taxable reward is also available.
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