Vesting Explained: What You Need to Know

February 23, 20247 min read
Vesting Explained: What You Need to Know
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Key Takeaways 

  • Vesting is the process through which an employee gains the right to exercise or own certain assets over a certain period. 
  • When an employee reaches their specific vesting date, they are entitled to a plan’s or asset’s full value or benefits.
  • Employees who leave their company before becoming fully vested will forfeit any unvested money, which will be returned to the employer. 

Investors and pre-retirees would do well to understand vesting, which can help with decisions regarding equity compensation and long-term investment strategies, as well as with retirement planning. 

In this article we’re covering all aspects of vesting as well as the nuances of vesting schedules, in addition to the long-term benefits and risks associated with stock options, 401(k) plans, and other equity-based pay.

What is Vesting?

Vesting is the process through which an employee gains the right to exercise or own certain assets over a certain period. Such assets can include shares, options, or other types of equity compensation.

When it comes to corporate finance, vesting is commonly associated with equity-based compensation, such as restricted stock units or stock options.

What Happens When You’re Fully Vested?

When an employee reaches their specific vesting date — the date on which an employee can exercise their rights or claim the pledged benefits — they are entitled to a plan’s or asset’s full value or benefits. This could mean company shares, retirement funds, or other employer-provided benefits

In other words, when a person is fully vested, they can take total advantage of the plan or asset without the risk of losing it due to resignation, termination, or other factors.

For example, in a common schedule, 25% is vested after the first year followed by another 6.25% each subsequent quarter until the fourth year when the employee is fully vested. 

What Happens if You Leave a Job Before You’re Fully Vested?

Employees who leave their company — they quit or were terminated or laid off — before becoming fully vested will forfeit any unvested money, which will be returned to the employer. This can be a substantial financial loss, particularly if those funds were counted on for retirement.

An Example of Vesting 

Say an employee is offered 300 shares of stock options with a three-year cliff vesting schedule. The employee may not exercise them for three years. After that, they are free to exercise the options at the initially agreed-upon price and sell the shares.

In a 401(k) example, say a company’s vesting schedule covers six years. After two years, the employees become vested in 20% of their company’s matching contributions. After four years, they are 60% invested, and after six years, fully invested.

Instituting a Vesting Schedule 

Because unvested equity may be forfeited or subject to dilution, investors must consider vesting schedules when assessing the prospective value of equity-based compensation. 

These schedules are predetermined plans that delineate the percentage of equity available to an employee at certain points during the vesting period. Commonly, the vesting period is four years, typically with a one-year “cliff.” Here, the employee must stay with the company for a year before any part of the equity grant vests. After that, the remaining equity vests over the next three years.

Once a portion of the equity grant has vested, the employee is free to sell or exercise it, subject to tax implications or any applicable restrictions. 

Types of vesting schedules include:

  • Time-based. Employees are granted equity based exclusively on the passage of time. The “four-year investing with a one-year cliff” scenario is an example.
  • Performance-based. These schedules link equity vesting to specific milestones that can be based on employee, team, or company performance.
  • Annual. Here, a fixed percentage of the equity grant vests at year’s end, usually over a three- to five-year period. This type of schedule can be linked to a cliff, requiring the employee to stay with the company for a certain period before any equity vests.

Note that vesting schedules can vary markedly among companies and depend on the equity grant type and the employee’s organizational role. 

Factors that influence schedule choice include employee retention and motivation. For example, annual vesting and time-based schedules generally provide more predictable vesting, permitting employees to better plan their financial future. By contrast, performance-based vesting can spur employees to achieve specific goals, prospectively resulting in faster company growth.

What is 401(k) Vesting?

If an employee is fully invested in their 401(k), they have been with the company sufficiently long for complete ownership of all retirement-plan assets. Such assets include employer-matched funds — commonly between 3% and 6% of the employee’s earnings — or company stock.

Money the employee contributes, regardless of their vesting status, is owned by them. On the other hand, employer contributions are at risk of reclamation if the employee leaves before they are vested.

What is a Vested Balance in 401(k)?

The vested balance in a 401(k) is what the employee owns outright and cannot be retaken by the employer if the employee loses their job or otherwise leaves the company.

To determine their vested balance, an employee can check with their employer’s benefits administrator.

What is Stock Vesting?

With stock vesting, a stock option holder achieves equity ownership over time according to a preset vesting schedule. In other words, it is the process through which employees earn full equity ownership over time by meeting certain milestones.

The three approaches here include cliff, graded, and immediate vesting. With cliff vesting, a participant gains full asset ownership on a given date. With the graded approach, the employee gains ownership in intervals. Immediate vesting calls for the employee to receive 100% ownership of their shares at the grant date.

Vesting RSUs

A restricted stock unit is an award of shares as a form of stock-based employee compensation that is conditional. Here, a condition is the completion of a vesting period, which may last several years, before the shares are transferred. The employee must achieve mandatory performance milestones or remain with their employer a certain length of time.

Because RSUs are included as W-2 income, the employee is taxed at ordinary tax rates on the shares’ value. They incentivize employees to remain with their employer and help it perform well so that their shares rise in value.

Retirement and the Private Market 

Employee vesting notwithstanding, there are ways to potentially help fund retirement that have little correlation to an intrinsically volatile stock market. Namely, through alternative investments.

Such investments are increasingly popular as a way to avoid constant fluctuations and protect against inflation. After all, the private market has performed better than the S&P 500 in every economic downturn of nearly the last 20 years.

The leading alternative investment platform is Yieldstreet, on which $4 billion has been invested to date. From art to real estate, it offers more asset classes than anyone else. It also has a private-market IRA. While every investment carries risk, Yieldstreet seeks to create passive income streams outside of traditional public markets.

Yieldstreet’s offerings, which are first subject to a robust vetting process, provide access to investments traditionally reserved for institutions and the ultra-rich, with net annualized returns of some 9.6%.

Such investments also serve another essential purpose: diversification. Creating a portfolio composed of varying assets can decrease overall risk and potentially improve returns. In fact, diversification is an elemental pillar of long-term investment success.

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Alternative Investments and Portfolio Diversification

Alternatives can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.

To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments.

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary 

It is important for prospective investors and pre-retirees to know the ins and outs of vesting and its various applications, including the nuances of vesting schedules. Such knowledge can help with decisions regarding equity compensation and long-term investment approaches. Likewise, it is also important to understand the long-term benefits and risks of equity-based compensation.

We believe our 10 alternative asset classes, track record across 470+ investments, third party reviews, and history of innovation makes Yieldstreet “The leading platform for private market investing,” as compared to other private market investment platforms.

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