Performance Based Vesting - Explained
What is Performance Based Vesting of Stock Options?
Written by Jason Gordon
Updated at July 2nd, 2021
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Table of Contents
What is Performance Based Vesting of Stock Options?Examples of Performance Based VestingAcademic Research on Performance Based VestingWhat is Performance Based Vesting of Stock Options?
Vesting is a time bound stock ownership plan that allows employees, directors, owners, and entrepreneurs to acquire equity in the firm theyre working for. The Vesting Plan decides how and when the owners and employees gain access to or keep their shares. Introduction of a performance based criterion to this Vesting Plan will make this a Performance Based Vesting structure. Instead of time duration, the stocks would only be vested if they hit certain targets within a specified period like a quarter.
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Examples of Performance Based Vesting
Regular Vesting Example
A new employee is awarded 1000 stocks in the company as part of the pay package, but the employee only gains ownership of these stocks at the rate of 25% per year. This Vesting Plan, a.k.a the Graded Vesting Model, would be completed in 4 years with the employee gaining ownership of 250 shares per year, conditional upon the employees continued employment with the company. This is a regular time bound vesting schedule
Performance Based Vesting Example
Suppose an employee gets offered 1000 stocks of a company that are publicly trading at $80/share. The vesting is conditional on the stocks hitting the $90 mark for the current quarter. 10% of the 1000 shares get vested every quarter only if the stock price hits a predetermined goal for that quarter. This is Performance Based Vesting of stock units. The employee can only gain ownership when the quarterly performance goals of the stocks are met. Vesting plans are vastly different for owners and employees and operate on different conditional criteria and time bound scales.
Advantages of Performance Based Vesting
Vesting schemes allow owners and employees to benefit from improved securities performance even as it safeguards the interests of the firm in the long run by making it conditional upon stringent criteria. In business verticals with high churn rates, where expecting employees to stay loyal for years isnt feasible, a Performance Based Vesting plan can attract top talent as well as act as a sop to get the best out of employees. Since the Vesting Plan is tied to the performance or other goals related to company's stocks, which in turn is tied to the performance of the company, i.e., the collective performance of individuals, it keeps employees on their toes to give their best to the company to achieve the conditional predetermined goals. It is a way of rewarding founders working for equity in the company without cash strapping a budding business.
Academic Research on Performance Based Vesting
- Stock and option grants with performance-based vesting provisions, Bettis, C., Bizjak, J., Coles, J., & Kalpathy, S. (2010). The Review of Financial Studies, 23(10), 3849-3888. This review studies the impact of different Performance Based Vesting of stock options on performance with data from 983 firms.
- Performance-vesting provisions in executive compensation, Bettis, J. C., Bizjak, J., Coles, J., & Kalpathy, S. (2018). Journal of Accounting and Economics. This journal takes a look at Performance Based Vesting (P-V) used to reward executives and their compensation packages.
- Performancevested stock options and earnings management, Kuang, Y. F. (2008). Journal of Business Finance & Accounting, 35(910), 1049-1078. This journal studies the effects of P-V on managers engagement and earnings.
- On the Performance-based Equity Incentives, Exercise Rights Vesting Performance Requirements and the Growth of Shareholders' Wealth [J], Yunsen, X. D. C. (2010). Journal of Financial Research, 12, 011. This journal sheds light on shareholders perception of and reaction to P-V equity plans for executives.
- Equity vesting and managerial myopia, Edmans, A., Fang, V. W., & Lewellen, K. A. (2013). National Bureau of Economic Research. This paper investigates the effects of P-V equities on managerial short-sightedness.
- Accelerated vesting of employee stock options in anticipation of FAS 123R, Choudhary, P., Rajgopal, S., & Venkatachalam, M. (2009). Journal of Accounting Research, 47(1), 105-146. This paper takes a look at the accelerated P-V schedules brought in effect between March 2004 - November 2005, by firms anticipating the implementation of Financial Accounting Standard (FAS) 123 - R rule, by the Financial Accounting Standards Board (FASB) in December 2004.
- Pay for the right performance, De Angelis, D., & Grinstein, Y. (2012). This paper discusses the case for P-V equity plans to reward the right people.
- Expensing stock-based payments: A material concern?, Chalmers, K., & Godfrey, J. M. (2005). Journal of International Accounting, Auditing and Taxation, 14(2), 157-173. This paper sheds light on the way a P-V equity plan is accounted for in assessing the performance of a business and proposes that if vesting were to be expensed, it would significantly change the way companies performances are evaluated.
- Non-price and Price Performance Vesting Provisions and Executive Incentives, Core, J., & Packard, H. (2017). This paper presents a comparative study of price based and non-price based criterion for P-V equity plans provided as incentives to executives.
- The value of vesting restrictions on managerial stock and option holdings, Chi, J. D., & Johnson, S. A. (2009). This papers draws the correlation between vesting restrictions and managerial performance in light of their allocated holdings and options with the help of an events study.