ESOP Vesting is defined as the process through which employees can apply for shares of the company against their equity grants.
If an employee has received an options grant, he/she must carefully read through the company’s ESOP scheme document, grant letter, etc to understand his/her rights and restrictions. The ESOP scheme provides key details such as ESOP pool size, default vesting schedule, exercise period, share transfer restrictions, how vested/unvested options are handled when an employee exits, etc.
If an employee is granted 10,000 options with 25% of them vesting per year for four years with an exercise period of 10 years, the employee will have the right to exercise options and have the right to buy 2500 shares after one year from the option grant date. The next 25% would vest two years from the grant date, and so on. If the employee decides not to exercise all 25% vested ESOPs after year one, there would be a cumulative increase in exercisable options. Thus, after year two, the employee would have 50% vested ESOPs. Similarly, if the employee does not exercise any of his/her ESOPs in the first four years, he/she would have 100% of the ESOPs vested after that period, which can be further exercised in full or in parts. If the employee does not exercise options within the exercise period of say 10 years, the granted options typically lapse and return back to the ESOP pool, and the employee loses the right to purchase vested stocks.
When employees depart before all their grants are vested, the unvested grants get lapsed and are returned back to the ESOP pool. However, the vested options are retained by the employee for a certain exercise period that is allowed by the company as per the ESOP scheme terms and conditions. This could be anywhere between a few months to many years. Of course, the larger time the employee gets for exercise post his departure, the better it is from his perspective because of the high-income tax that is charged at the time of exercise.