What it means
The simplest case is a share grant that vests over time. Vesting means that the employee gradually earns the right to the shares, for example 25% a year over four years.
Until the shares vest, they are deferred, and an employee who leaves early typically forfeits the unvested portion. Companies use deferred equity to keep and motivate talented people without paying large amounts of cash.
It is especially useful for start-ups, which often have more potential than cash. The employee benefits if the company grows, and the company keeps its cash for operations.
In acquisitions, a buyer may pay part of the price in shares that are issued later, sometimes linked to performance targets known as earn-outs. This reduces the buyer's upfront risk, because the seller only receives the full value if the business performs.
It also keeps the seller focused on the future of the business. From an accounting point of view, the company measures the fair value of the award on the grant date and spreads that cost over the vesting period.
This charge reduces profit even though no cash is paid. Existing shareholders should also expect dilution, which means their percentage ownership falls when new shares are issued.
There is a tax angle that varies by country, so recipients should take advice. The point at which tax arises can be the grant, the vesting or the sale of the shares, and that timing may affect how much cash the recipient needs to find.
A well-drafted plan sets out clearly what happens on leaving, sale of the company and other events. For private companies, valuing the shares is a practical challenge.
With no market price, the company often relies on an independent valuation or on the price of the latest funding round, and updates it regularly. Using stale valuations can make the accounting cost look wrong, so many boards refresh them at least once a year.
In practice
Real-world examples.
Example
A software start-up offers its first engineer 40,000 shares vesting over four years with a one-year cliff. If the engineer leaves after nine months, none of the shares vest, and they return to the company.
Example
A listed company buys a smaller rival for $10,000,000, paying $6,000,000 in cash and the remaining $4,000,000 in shares issued two years later if sales targets are met. The seller has a strong reason to help the business hit its targets.
Example
A founder team agrees that each founder's shares vest over four years, so that someone who leaves in the first year does not keep a large stake. Investors usually ask for this before putting in money.
Formula
Calculation
Vested shares = total shares granted x (months served / total vesting months)
Annual expense = grant-date fair value per share x total shares / years of vesting
An employee is granted 60,000 shares vesting evenly over 48 months. After 18 months, vested shares = 60,000 x (18 / 48) = 22,500. If each share has a grant-date fair value of $5, the total cost is 60,000 x $5 = $300,000. Spread over four years, the annual expense is $300,000 / 4 = $75,000.Case study
Seen in the real world.
Quillfeather Analytics is an illustrative, fictional start-up that wanted to hire a head of sales but could not match the salary offered by larger firms. It offered a lower salary together with 100,000 shares vesting over four years.
The head of sales joined and built the sales team, and by year three the company was valued much higher than at the grant date. The vested shares were worth far more than the salary difference. The arrangement also kept the head of sales committed for four years, which suited the founders as much as the individual.
Quillfeather is a made-up company, so the numbers are for teaching. The finance lead recorded the share-based cost each month and showed existing shareholders how the new shares would dilute their stakes.
Watch out
Common mistakes.
- Treating unvested shares as if they already belong to the employee, when they can be lost if the employee leaves.
- Ignoring the accounting charge because no cash is paid, which understates the true cost of employment.
- Overlooking dilution, so that existing owners are surprised by how much their percentage falls after awards.
Questions
People also ask.
What is a vesting cliff?
It is an initial period, often one year, before any shares vest, after which a block vests at once and the rest follows gradually.
Is deferred equity the same as stock options?
Not exactly, because shares are owned outright once vested, while options give the right to buy shares at a set price.
Does the company pay anything when shares vest?
Normally no cash is paid by the company, but there may be tax withholding, and the cost has already been recognised in the accounts.
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