What is vesting?   

Vesting, in a legal sense, presupposes giving or earning a right to an asset, present, future payment or benefit. Vesting means the point in time when a party will gain legal ownership of an asset. 

A vesting agreement is commonly used as a method of compensation for corporate executives and to fulfil the requirement for many company-funded retirement plans. A vesting period can also be applied to the requirements of receiving an inheritance or included within the conditions of property ownership. 

Examples of the latter could be inheriting a house where the conditions of the inheritance require you to live in it for a set period of time before you can legally obtain ownership, or purchasing a property where a condition of the purchase is that a right of way be granted at a certain date in the future. 

Typically, vesting examples are found in compensation packages for employees. These benefits may be in the form of stock options that give the employee the right to purchase stock at a (hopefully) lower amount than the market price or, for example, in the form of employer-funded retirement savings contributions. 

A vesting schedule is a tool used by employers to encourage an employee to stay employed for a longer period of time and work towards the success of the company – in other words giving them a ‘vested’ interest in continuing or extending their employment. 

Types of vesting 

There are three main types of vesting. The kind of vesting it is depends mainly on when the ownership of the asset transfers. 

• Immediate vesting. As the name would imply, this is when you receive full rights to the asset immediately as you receive the asset. This could be in the form of stock options that vest on signing an employment contract or retirement benefits that vest on receipt during every pay period. 

• Graded vesting. Many compensation packages include a graded vesting schedule. In this type of vesting schedule, a certain percentage of the compensation transfers at defined intervals. Typically, graded vesting arrangements will increase in percentage over time on a linear scale to incentivise the employee to continue working for a longer period. 

• Cliff vesting. This type of vesting definition states that ownership of the entire asset will be withheld for a certain period of time, at which point 100% of the ownership is then transferred to the employee. This arrangement is usually reserved for high-level executive pay packages in the form of stock options, and is less frequently used for retirement packages. 

How does vesting stock work

Compensation in the form of stock will usually take the form of vesting options. These stock options give the receiver the right to purchase stock in the company at a predetermined price. 

Compensation in the form of stock options will typically require the employee to work in good standing for a set period of time before ownership rights are transferred to prevent them from simply cashing out and moving to the next job. 

These forms of compensation are particularly enticing as the idea is that the set purchase price will be below the market value of the stock when the option vests. Vesting stock options are commonly used as a large percentage of executive compensation, as they both entice the employee to continue working for the company as well as help grow the share price so the employee receives a larger profit when the stock reaches maturity.