Vesting Schedules for Stock Options

One of the key considerations in setting up a stock option plan is establishing a vesting schedule. A vesting schedule, outlined in the stock option agreement, details the amount of time it takes for employees to become entitled to an increasing percentage of their company stock options.

Some companies offer new employees immediate vesting as a type of sign-on bonus. Others structure their plans so that options vest over a period of years, creating an incentive for employees to remain with the company. Still other businesses reward employees for hard work through performance-based stock options plans that vest incrementally when certain performance goals are met.

In general, the type of vesting schedule you choose will depend on two things: how you want to use the stock options -- to attract, motivate, reward or retain employees -- and whether you have a qualified or nonqualified stock option plan.

Vesting Schedules for Nonqualified Options

Most broad-based stock option plans are structured as nonqualified options. In general, nonqualified stock options are not regulated as elaborately as qualified stock options and allow for a more flexible vesting schedule.

Companies with broad-based stock option plans typically follow a 3- to 5-year schedule that vests a certain percentage of options each year. But the most common schedule vests an equal percentage of options (25 percent) every year for four years, according to study of broad-based stock options by the National Center for Employee Ownership, a private nonprofit membership and research organization.

Vesting Schedules for Qualified Stock Options

Qualified stock options, such as those granted through employee stock ownership plans (ESOPs) are regulated by the Employee Retirement Income Security Act of 1974 (ERISA). It requires that businesses with ESOPs offer one of two minimum vesting schedules to their employees: cliff vesting or graded vesting.

Under a cliff vesting schedule, options vest all at once or 100 percent after five years of service. Under a graded vesting schedule, employees are 20 percent vested after three years of service and become 20 percent vested each year after that until they are 100 percent vested after seven years. However, certain qualified plans are not subject to ERISA -- for instance, most ISO plans.

In both qualified and nonqualified stock option plans, employees who terminate their employment are entitled to receive the vested portion of their accounts. Otherwise, employees receive the vested portion of their accounts upon retirement, disability or death.