How Do Unvested Shares Work?

by Beulah Pene

March 30, 2021
Blog, Editor's Pick

Introduction

Understanding how unvested shares work is really important if you are part of an Employment Share Scheme (‘ESS’), or wish to enter into a share vesting agreement. We are going to explain how unvested shares work in this guide. First, we’ll explain what shares are. Then we’ll distinguish shares, particularly unvested shares, from options. Finally, we’ll consider how unvested shares work in the context of an ESS.

Shares or stocks are basically contracts granting you part ownership of a company. To understand how unvested shares work, you need to clearly distinguish shares from share options. As such, we are going to go into a bit more detail on two things. First, we’ll look at how shares differ from options. Then, we’ll look at how shares and options are offered in an ESS.

Shares v options

Shares and options are complex financial instruments commonly used in the commercial world. The key difference you need to know between them is what rights they offer the contract holder. If you enter into a share contract, you are granted part ownership of a company. As such, you get a bunch of shareholders’ rights in connection with the management of that company. You also get an entitlement to part of the company’s profits. On the other hand, if you purchase share options, you do not immediately get part ownership of a company. Instead, you get the right to obtain shares on or before some specified date in the future. This will be for some specified price. As the name suggests, there is no obligation to exercise that right.

You typically get shares and options of a company you work for through an ESS. We can assist you in creating one. Their main advantage is that they offer additional benefits to employees at no upfront cost to the employer. These benefits are closely tied to the performance of the company, and thus the employees; the more a company grows, the more your shares will be worth. To achieve this means of inspiring employee motivation and loyalty, these schemes typically offer shares and options through vesting arrangements. These schemes can be subject to special tax treatment. This can make them more favourable than other forms of share and options vesting agreements. We’ll explain more on this in the section ‘Unvested shares in an ESS‘ below.

Offering shares on a conditional basis is referred to as a share vesting arrangement. The arrangement can make the condition time-based. This is where shares are granted on the expiration of a certain amount of time. Additionally, this grant can be split across several specified time periods. This means that you get a portion of the shares in the vesting agreement at the expiration of each period. The condition can also be milestone based. It operates the same way, except the share is granted on the occurrence of a particular event. These conditions will often mean that the shares are not granted until some time in the future. However, this does not make shares in vesting agreements the same as options.

Vested shares v options

We call shares actually granted in a share vesting agreement vested shares. This is because it may be that only a portion of shares have been granted. For example, this would happen if only some of the specified time periods have expired. This differs from an option because you are given your share entitlements immediately. A share option contract may specify that your right to obtain shares arises at some point in the future. However, this right has to be exercised for you to get your share entitlements.

Unvested shares v options

We call shares which are pending in a share vesting agreement unvested shares. For example, this would happen if the conditioned milestone hasn’t occurred yet. Shares may be pending in a share option contract which allows you to obtain shares at any point up to a certain point in time. However, you have to actively exercise that right to obtain them. As such, your share entitlements are pending the exercise of those rights.

Unvested shares in an ESS

Now we are going to look closely at how unvested shares work in an ESS. However, you should keep in mind that how unvested shares work can differ according to the relevant arrangement. For example, you might use a share vesting agreement in founding a start-up venture instead of an ESS.

Unvested shares in an ESS

As we mentioned earlier, shares in a company are typically offered to the company’s employees under an ESS. Additionally, this is typically through vesting arrangements. This is because employers can condition the vesting of shares on milestones the company wishes to achieve. Additionally, they can motivate employee loyalty. They do this by conditioning the vesting of shares on the length of the employee’s employment. If the milestone isn’t achieved, or the employee leaves before the conditioned time period, the agreement will stipulate what happens to unvested shares. For example, senior employees’ and executives’ unvested shares may be immediately vested when their company is acquired by another company. Additionally, regular employees’ unvested shares may be forfeited if they leave before conditioned time periods.

Conclusion

In conclusion, unvested shares are shares which have not yet been granted under a vesting agreement. If you hold unvested shares, you are immediately entitled to your shares when the conditions of the vesting agreement are satisfied. This is different to options. For options, you need to actively seek the shares for you to get your entitlements. Finally, in the context of unvested shares under an ESS, regular employees typically forfeit their shares if the conditions of the vesting agreement are not met.