Vesting is simply the rights an employee acquires by working for a company for a specific length of time. Companies frequently tie the right to participate in certain benefit programs such as stock option programs and pension plans to a vesting schedule.

A vesting schedule states the length of time an employee needs to be employed to earn rights to the benefit programs. For example, a company may require three years of continuous, full-time employment to be eligible for the pension plan.

The company may require you to complete the full vesting schedule before any benefit is accrued. Using the preceding example, the company may require the employee to complete the three-year vesting requirement before any pension benefits are available.

The term vesting means different things depending on whether you are talking about options or stock. This chapter focuses on the vesting of options. Stock vesting is covered in Lesson 12, "Options and the Private Company."

Employee stock option programs often contain a vesting schedule. The reason is companies use employee stock options to encourage workers to stay with the company. It makes sense that they would want to provide an incentive for employees to stick with the company.

Recruiting and training skilled workers represents a big investment for a company. A stock option program is one way to attract and retain employees that doesn't cost the company a lot of money.

Employees who stick with a company may enjoy significant benefits if the stock rises during the vesting period. Many companies issue new grants on a regular basis, providing the employee with an ongoing reason to stay. Employees who leave before an option is vested lose them.

This is particularly true for highly paid managers. They often receive incentive stock options (ISOs), which have specific vesting requirements. As stated in Lesson 1, "Employee Stock Options," some senior corporate officers receive the bulk of their compensation in stock options and stock.

For example, the president of a new Internet startup might be offered the following stock options over and above a salary:

This schedule pushes the bulk of the stock options into years three and four (70 percent). These incentives for management are to get the company through an initial public offering (IPO) and keep the stock price up. The higher the stock's price, the more valuable the options are. At the same time, the vesting schedule encourages the president to stick with the company because the bulk of the option's benefit is in years three and four.

Should the president leave at the end of two years, for example, she would probably lose the remaining 70 percent of the vesting schedule. Some of the Internet startups have generated such high stock prices that leaving 70 percent of the vesting schedule behind would cost the executive millions of dollars.

ISOs require a holding period to receive the favorable tax treatment, which encourages further employment continuation.

The same Internet startup company may also offer NSOs (nonqualified stock options) to the rest of the employees. Although NSOs have no particularly favorable tax treatment, they can still be used to encourage employees to stick with the company through the vesting schedule.

One of the most common schedules is a four-year one that vests 25 percent each year. For example, if a worker is granted stock options for 100 shares with a four-year vesting schedule, at the end of each year the employee would be vested in 25 percent or 25 shares. Twenty-five additional shares vest each subsequent year.

It is worth noting that vesting gives you the right to exercise the options, but does not obligate you to do so. If the stock's price is lower than the grant price one year (say year two), the employee would probably skip exercising the vested 25 shares for that year. Should the stock's price improve by the end of the next year (year three), the employee would have 50 shares vested—25 from the previous year (year one) and 25 from the current year (year three).

Vesting simply gives you the right to exercise the options. You should determine if it is the best time or not based on the stock price and other considerations such as your current tax situation, other financial goals, or how much of the company's stock you currently own.

Many companies make employee stock option grants on a regular schedule. Each grant may have its own vesting schedule that may or may not be the same as previous grants. Suppose a company grants options for 100 shares with a four-year vesting schedule each for three years in a row. A simple grant and vesting schedule might look like this:

Multiple grants vesting over the same term (four years) provides overlapping of vesting. Each grant would have a different strike price based on the stock's performance, so options issued one year may be worth more than options granted another year.

If you are fortunate enough to work for a company that regularly grants employee stock options, you will need a system for keeping track of the vesting schedules. It is hoped your plan administrator will provide you with reports to help you keep all this information straight, but if not, try this work sheet.

You can do this on paper or convert it to a spreadsheets program like Microsoft Excel or one of the others on the market for personal computers. I am using the same example as above for this work sheet.

An options grant on January 1, 1999, would be partially vested on January 1, 2000. If your employer regularly uses a different date, then you can adjust the work sheet. For example, if the grant date is always June 1, then the first vesting period concludes on May 31 of the next year and you would be partially vested (25 percent) on June 1 of that year.

As you can see, each grant has its own strike price, which is probably typical of employee stock options for publicly traded companies. You can use the work sheet to see how many vested options you are entitled to and at what strike price in any year.

For example, the year is 2003 and you want to exercise some of your options. The current market price of the stock is $25 per share.

Using the work sheet, you can quickly see that you are vested in …

Based on this information, you decide that the difference or spread of the option with strike price of $26 is negative, so you don't want to exercise those options. You should hold on to them because it is possible they may become profitable in the future. You have until the end of the option term to decide, unless you retire or leave the company.

The options with a strike price of $24 per share are barely profitable, so you don't want to exercise those. However, the options with a strike price of $20 per share are profitable by $6 per share, so you exercise those.

This simple exercise does not take into account whether the options were nonqualified or incentive. It also does not consider the tax consequences. I discuss these concerns in more detail in later chapters.

Many employee stock options are good for 10 years from the grant date. This gives you a long time to decide when or if you are going to exercise the options.

Employee stock options usually can be exercised up to one year after you retire or separate under good terms from your employer. Every plan may be different on this point, so be sure to double-check. Most plans require fired workers to immediately exercise their vested options.

If you die while still employed, most plans allow your heirs a certain period of time to exercise the options. Your attorney can make the necessary adjustments to your will.

ISOs require an employment period to meet the tax code guidelines for favorable capital gains treatment. If you leave before this period expires, the options will become NSOs and lose the tax-favored treatment.

Employees forced to leave because of a disability usually have a period of time to exercise vested options. Check with the plan administrator for particulars of your plan.

Some companies that grant immediately vested options may put a short time restriction on the options, called a lockup period. These lockup periods become very important when we look at employee stock options and the initial public offering (IPO) in Lesson 10, "Taxes and Your Options."

A lockup period is usually less than a year in length, although there is no rule to say it can't be longer. The company can also set different lockup periods for different classes of employees.

For example, rank-and-file hourly workers may have one period, while managers may have another. As long as the lockup period is not discriminatory (men have one term, women another, for example), the company can structure the periods any way they want.

The lockup period begins on the grant date of the options and is not connected to individual employees. An employee of six months may have the same lockup period as an employee of six years.

Companies use lockup periods for a variety of reasons. Some companies may use them as a cooling-off time to avoid everyone exercising his options immediately. As shown in Lesson 10, there may be certain legal or business reasons connected with the company's IPO for imposing a lockup period.