Raj is a 42-year-old individual working in a startup that compensates him with ESOPs in addition to his annual package. The typical vesting schedule for ESOPs is around 3-4 years, and the same is the case with Raj. Vesting refers to the process by which an employee acquires a stock option, which is his “vested” interest.
Raj’s ESOPs will vest at the end of his fourth year in the company, after which he will be able to exercise his option. This means that he can buy the stock at the price set initially by the company grant, regardless of its price at the time of purchase.
ESOPs (Employee Stock Option Plans) are granted to align the incentive structure of the employee with the goals of the company. A specific portion of the stock options vests each year until the entire stock grant is vested.
With that comes the expectation to be employed with the company through the vesting period. Often companies award additional grants to an employee as the role expands. These can serve as a strong retention and value-creation tool.
Employee departures are the primary reason many employees lose stock option plans, rewards, or RSUs (Restricted Stock Units).
Coming back to Raj, what happens to his ESOPs when he leaves the company would depend on his tenure with the company and the type and the stage of the ESOPs.
What happens to vested but not exercised options?
Let’s start with a basic and simple example. If Raj leaves the company after completing four years, his stock options would already be vested at the time of leaving the company. He has the opportunity to benefit from his ESOPs by exercising them.
Typically, vested stocks have two categories: non-qualified stock options (NQSOs) and incentive stock options (ISOs).
If Raj has NQSOs, he will have the flexibility to exercise his stock options depending on his employer’s policy, compared to ISOs. The latter may tie his exercising period to 90 days from the time he leaves the company. Note that ESOPs are only lucrative if employees have the opportunity to sell the shares for more than the exercise price. This can happen in three scenarios:
Shares can be sold in public markets at the prevalent value. The employee can decide when to sell.
Companies can decide to buy shares back at the Fair Market Value (FMV). Most companies have an FMV that is linked to the last funding round or any other recent valuation.
Companies often facilitate exits to funds or individuals interested in buying their stock.
Many companies have a requirement to buy the shares within 30-90 days of exit.
Now, let’s take a different perspective.
If we consider that Raj has not completed four years and his options are yet to be vested, he will, unfortunately, lose the unvested portion. So, if the vesting schedule was 25 percent vesting every year, and Raj decides to move on after 2 years and 5 months, he will lose 50 percent of the stock grant.
What happens to employee stock purchase plans (ESPP)?
Raj’s stock plan might also include ESPPs. Consider it as an SIP in your company’s stock. This often has a 10-20% discount to the market price.
When Raj leaves the company, he would have the right to his existing share of stock with the company. He can continue holding the stock for longer if he believes in the long-term prospects of the company. However, he will not be able to participate in the equity programme anymore.
If we consider that the amount to participate in ESPPs is deducted from Raj’s salary, any amount not yet invested will be credited back to him.
What happens to RSUs, stock appreciation rights, and restricted stocks?
RSUs (Restricted Stock Units) are shares that are granted at zero cost to the employee. Hence, the entire value is in the hand of the employee at the time of the vesting. RSUs typically vest over a 1-4 year period. If Raj possesses vested RSUs or restricted stocks, he will continue to have ownership of his shares even after leaving the company as they are already vested and converted into stocks. He has the freedom to hold or exercise these stocks as per his preference.
Let’s consider that Raj’s company heavily relies on stock options for compensating employees for their performance and bonus. In lieu of actual shares, his employer provides him with stock appreciation rights (SARs). These are also known as phantom stocks.
While the employee doesn’t have actual stocks, s/he has the right to benefit from the increase in the stock price. Consider it as SARs are paid out by the company at the time of vesting or liquidity. In such a situation, when Raj leaves the company, he will have to forgo his ongoing rights on SARs since he wasn't provided with the actual shares but a potential benefit of share price appreciation.
It is always advisable to read the clawbacks for SARs to better understand the vesting and exercising structure.
What happens if the company lets go of employees?
If Raj’s company decides to fire him with cause, he will lose all his vested or unvested stock options. However, if it is a layoff, Raj will still probably get time to exercise his vested stock. His unvested options will be void.
In case Raj’s stock options include RSUs or SARs, he would have to let go of any rights on unvested equity allotted to him earlier, whether he is fired or laid off.
What can you conclude?
ESOPs are a great way to generate wealth, especially when the company is doing well and is creating incremental value with every passing year. It is important to understand the stock grant policy of your company. Do ask your HR or management if you are unclear.