New to a startup? Chances are, you have been offered stock options as part of your compensation. To incentivize you to stay with the company long-term, your employer will likely put a vesting schedule on your options. This means that you will not be able to exercise and own all of your options immediately – you will have to wait for a certain period of time, known as the vesting period, before they vest.

For those that are completely new to the topic, here’s how the process typically works for stock options:

Your company gives you the right to buy a certain number of shares of the company's stock at a set price, called the “strike price”. This right to buy the stock is available to you over a certain period of time. This is called “vesting”. You get more of the right to buy the stock depending on the predetermined schedule. When the stock's value goes up and you think it's a good time to sell, you can “exercise” your options and buy the stock at the strike price, then sell it for a profit.

Please note the above is an oversimplification and exercising involves more nuance – something we have explained in other articles.

What is a Stock Option Vesting Schedule?

A vesting schedule is simply a plan for when an employee can exercise their stock options. For example, a company may have a four-year vesting schedule, meaning an option holder can exercise all of their options only after four years of employment.

There are a few different vesting schedules, but the four-year vesting schedule is the most common. Some vesting schedules include cliffs, accelerated vesting in case of an upcoming liquidity event, and vesting upon the achievement of a particular milestone.

So why do companies use vesting schedules? Vesting schedules are designed to align everyone’s interests with that of the company. By making option holders wait a certain amount of time before they can exercise their options, the company ensures that they are invested for the long haul.

What are the different types of Vesting Schedules?

Cliff Vesting

Under this structure, an employee does not vest any shares until a specific “cliff” period has passed, after which they vest a certain percentage of shares, all at once. Post the cliff, options start vesting at any frequency set up by the company (daily, monthly, quarterly, annually).

For instance, an employee on a four-year cliff vesting schedule would typically vest 25% of their shares after the first year (cliff) and 2.08% every month or 6.25% per quarter post that.

This is also the most common form of vesting schedules among startups, as this incentivizes employees to stay on for at least one year after receiving the options, and once they do, they end up staying for a longer period of time.

Graded Vesting

Post the cliff period, employees vest a certain percentage of shares on regular intervals like monthly, quarterly, or annually under graded vesting.

Suppose you are offered 300 stock options with 5-year graded vesting. They would be entitled to 60 stock options (20% of total shares) after their first year of employment and so on.

Immediate Vesting

As the name suggests, under this structure, employees get full ownership of their options immediately after receiving them.

Immediate vesting is often used in cases where the company wants to reward or retain key employees or in situations where the company wants to attract top-tier talent for roles high up the pecking order.

ESOPs under Indian laws do not allow for vesting before at least one year of grant, so some companies may issue Stock Appreciation Rights (SARs) which may not have a vesting period.

What happens after my options have vested?

You have the right to purchase shares in exchange for your vested options.

Let’s assume you have 1000 vested options in your company. You can buy them for 1000 shares in the company at the predetermined strike price. This is typically at a nominal value.

However, do note that there will be a tax liability due immediately after you have exercised your stock options.

Is it necessary to exercise my options after they have vested?

Not really. It is good to read the fine print of your grant letter to get better answers here, but startups who have the wellbeing and wealth of their team in mind, tend to have a 10-year exercise period for stock options.

If in case you are planning to quit and have vested options, do take a look at your post-exit exercise window. This varies between 90 days and 10 years.

P.S. It isn’t unheard of to find companies that terminate all your options (vested or not!) as soon as you leave the company.