Value of vesting provisions

Johnson, T (2001) Value of vesting provisions. Working Paper. London Business School IFA Working Paper.

Abstract

Employee stock options and other forms of deferred compensation typically include provisions stipulating forfeiture upon termination of employment prior to some date. This paper considers the impact of such vesting provisions on the value of the deferred claim. The answer depends on the full specification of the employment contract to the vesting horizon. In typical contracts, the value surrendered in the vesting provision is equal to the value of the claim, rendering the benefit worthless to the employee. Used in this way, vesting provisions destroy any incentive effects the benefit may have been intended to produce. They can also be inefficient, negating any savings of longterm contracting and potentially leading to under investment. We characterize optimal explicit and implicit contracts that might overcome these problems, and outline empirical implications that would distinguish the hypothesis that their efficient use is the exception rather than the rule.