The vesting period in an ESOP is the initial period when participants do not have access to all of the rights that would otherwise attach to their options or shares. This article explains how they work.
Overview
Under an employee share scheme or option scheme (or 'ESOP'), participants receive shares or options in the company that employs them. Sometimes, these shares or options will be subject to a ‘vesting period’.
The vesting period is the period between the date the options or shares are issued, and the date the participant is able to exercise all of the rights that attach to them.
Where there is a vesting period, participants will not receive the benefit of all of the rights that attach to their shares or options until after the vesting period has expired.
Where the ESOP involves options, participants are not permitted to exercise an option until after the vesting period has expired. If a participant leaves the company during the vesting period, any unvested option would lapse or be taken to have been forfeited. Read more about employee option schemes work here.
Where the ESOP involves shares, similar principles would apply. If a participant were to leave the company during the vesting period, any unvested shares would typically be forfeited or sold at a discount (usually by way of buyback or sale to a third party for no consideration or at a discounted price). Read more about employee share schemes work here.
How long is the vesting period in an ESOP?
The length of the vesting period will depend on the rules of the scheme. There is no ‘standard’ vesting period. Vesting periods tend to be between 12 months and 3 years, depending on the structure of the scheme.
Do you need to have a vesting period?
There is no legal requirement for your ESOP to have a vesting period.
For option schemes however, vesting periods are almost standard. The central purpose of most option schemes is to ensure that participants remain loyal to the company over the medium to long term. If participants receive the full benefit of their options from the moment they join the scheme, the scheme is unlikely to provide much incentive for them to remain employed.
For share schemes, the position can be slightly different. This because the main commercial objective can be achieved through different means. For example, if a share is issued to an ESOP participant upfront, the rules of the scheme would normally contemplate the share being forfeited or sold at a discount if the employee leaves the company within a specified period. This mechanism has the same practical effect as a vesting period, even though it may described differently in the scheme rules.
The existence of a vesting period may also have consequences in terms of the tax treatment of the scheme. For example, where a participant's interests are subject to a real risk of forfeiture (such as under a vesting provision), this may allow the participant to defer the point in time at which they are required to pay tax on any discount they receive on their options or shares at the time they acquire them. (Whether the tax can be deferred will depend on the company's circumstances as well as other terms of the scheme. Read more about the tax treatment of ESOPs here.)
How do good leaver/bad leaver clauses work?
Some ESOPs will contain ‘good leaver’ or ‘bad leaver’ provisions. These provisions prescribe different consequences for different types of people who leave the company, depending on the reasons for their departure.
A typical ‘good leaver’ definition might include circumstances where the participant leaves the company because of serious illness or incapacity.
A typical ‘bad leaver’ definition would usually include resignation by the employee or termination by the company for serious misconduct.
Some ESOP rules will contemplate ‘good leavers’ being able to retain their shares, or being able to exercise their options, notwithstanding their departure during the vesting period.
Where a company includes ‘good leaver’ provisions in their ESOP, this is usually because the company wishes to maximise the potential incentive for employees, and to also assure participants that the company does not intend to act unreasonably if a participant has to leave the company for reasons beyond their control.
Rather than relying on good leaver/bad leaver provisions, some companies prefer to have a blanket rule to the effect that if a participant leaves during the vesting period, their ESOP interests will be forfeited – subject only to the board having an unfettered discretion to waive this requirement in appropriate circumstances.
Can you have other types of vesting rules?
A vesting period is like a waiting period. To receive the full benefit of the options or shares issue under the ESOP, participant just has to stay employed by the company for the relevant period.
However you can have other types of vesting criteria.
For example, some schemes are structured so that participants receive all of their options or shares upfront – but on the basis that those shares or options will only ‘vest’ if prescribed performance criteria are satisfied.
Some schemes are structured with both time-based vesting conditions and performance-based vesting conditions. This means that:
- participants’ shares or options are effectively earned over time, but only if certain performance targets are achieved, and
- once the shares or options have been earned, a vesting period will apply. If the participant leaves during the vesting period, their shares or interests may be forfeited (or sold at a discount), even if the relevant performance targets were achieved.
This type of arrangement is intended not just to incentivise employees in the short to medium term, but to also encourage employees to remain employed by the company for a period of time after the performance targets have been met.
Is an ESOP vesting period different to an ESOP restriction period?
In most cases, a vesting period will be different to a restriction period. A restriction period refers to a period of time during which an ESOP participant is prohibited from selling their shares or options. It is common for there to be an ongoing prohibition against selling shares or options in a company, even after they have vested.
More information?
You can learn more about employee share schemes and ESOPs here.
