The Basics of Equity Compensation

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skyscraperIf your employer provides equity compensation as a part of its benefits package, you can expect to receive a wealth of information about the program. If you’re new to the subject, the amount of information and the details can be daunting, especially if you’re not yet familiar with the basics. To help with that, let’s take a step back and view the big picture on equity compensation.

What is Equity Compensation?

Equity compensation is a catch-all term for non-cash pay offered to employees as part of a total compensation package. It may include employee stock options, restricted stock units (or awards), stock appreciation rights, performance shares, and other variations on these themes. Regardless of the type, equity compensation is a way for companies to attract, motivate, and retain key employees:

Attract: The appeal of a lucrative equity compensation package, offering the potential for significant wealth accumulation, can be a compelling factor in attracting key employees.

Motivate: Equity compensation can align employee and company success in a way salaries alone cannot. Everyone wins/loses together when the stock price rises/falls.

Retain: Equity compensation is often structured as a promise of future value through a vesting schedule that might occur years in the future. Those who leave may forfeit their future benefits.

For executives and others, equity compensation may make up a significant portion of a total compensation package, sometimes exceeding the value of their annual wage and bonus. Equity compensation can also be a valuable tool for private companies like start-ups and pre-IPO entities, as well as other types of tech companies. Private companies might not have the immediate cash flow to attract, retain, and motivate the best employees through competitive wages alone. So, they may include equity compensation as a potential upside reward, subject to company stock performance.

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If you receive equity compensation, it’s important to know what you have—and what you don’t. Unfortunately, understanding the subtleties may not be straightforward. Even the basics can be encumbered by jargon, legal rules, and potential tax traps associated with each type. The complications can become exponential when you combine multiple forms into a single plan.

Let’s dive into some of the details.

What are the Most Important Things to Know About Equity Compensation?

First and foremost, there is a wide variety of equity compensation, and each form might be governed by different rules and regulations. Also, compared to your colleagues’ packages, your specific agreement may have similar or differing terms and provisions.

As you do your due diligence on your equity compensation offer, here are four important details to focus on:

  1. Vesting: When will your equity stake go from unvested to vested? After vesting, you can exercise, sell, and otherwise “action” your shares, subject to any additional restrictions.
  2. Taxes: When will the value of your equity be taxed, and what might the taxable impact be under various projections and scenarios?
  3. Expiration: When will your employee stock options expire?
  4. PostEmployment: What happens to your equity if you leave your employer, whether due to retirement, resignation, or termination?

Some answers to these critical questions will be guided by legal standards. Others will be governed by your specific grant agreement. Regardless of the type of package you’re being offered, a working knowledge in these four areas of interest should provide a solid base from which to build your equity compensation acumen. You can continue the exploration in our Basics of Equity Compensation resource center.

What are the Different Types of Equity Compensation?

The first step in getting started with equity compensation is to learn about the five main types you might receive. These include: employee stock options, restricted stock units (RSUs), employee stock purchase plans (ESPPs), performance shares, and stock appreciation rights (SARs).

Let’s take a closer look at each of these types.

1. Employee Stock Options

Employee stock options give you the right to buy shares of company stock at a fixed price (known as a strike price or exercise price), usually within a certain period (often ten years from the grant date). If the company’s stock price increases above the fixed strike price, you can buy shares at the lower, fixed price. If the stock price decreases below (and stays below) the strike price after the grant, the options will likely go unexercised, since you could buy shares on the open market for less than the strike price.

In this context, stock options are unique among equity compensation types, in that the stock price needs to increase above the option’s strike price to have value. If it does not, the employee stock option may expire before it’s worth anything to you.

There are two types of employee stock options: non-qualified stock options (NQSOs) and incentive stock options (ISOs). The critical difference between the two is how they are taxed, particularly at exercise. ISOs are more complicated from a tax standpoint, but generally more tax-favorable; their profit realized may be eligible for long-term capital gains tax rates if certain conditions are satisfied. NQSOs, on the other hand, are taxed as ordinary income at exercise.

2. Restricted Stock Units (RSUs)

Generally speaking, RSUs are a promise of future value equal to a set number of company stock shares. We say “future value,” because the value of the units at grant is subject to restrictions and vesting criteria. This means you only take ownership of your RSU shares after a certain period or once certain performance conditions are met.

RSUs are considered full-value awards, because as long as the vested schedule (or other criteria) is met and the shares are delivered, they will be worth something to you, the employee. Again, this is in contrast to stock options, which can expire before they are of value.

When the RSUs vest and the shares are delivered, a taxable event occurs equal to the value of the delivered units multiplied by the number of units vested. The value is taxed as ordinary income.

3. Employee Stock Purchase Plans (ESPPs)

Qualified ESPPs allow employees to purchase company stock, potentially at a discount and potentially with the benefit of a lookback period. Without going into too much detail, this gives you a chance to purchase shares at a favorable price. If you decide to participate, you’ll usually do so through convenient payroll deductions over a set offering period. There are usually limits on how much you can contribute to the plan.

ESPP tax ramifications are notoriously complicated, regardless of whether you sell your shares immediately after purchase or hold them to obtain favorable tax treatment (by satisfying holding period requirements). Still, even after-tax, ESPPs might represent what amounts to free extra money from your employer. Don’t overlook the potential value of a good ESPP.

4. Performance Shares

Performance awards are often tied to meeting specific performance criteria. Criteria commonly include metrics such as earnings targets, ETIBA, sales, or return on equity, instead of being tied to the time elapsed.

Performance shares are often delivered as a form of RSUs. The performance metrics state that the employee can obtain a number of shares equal to a minimum, a target, or a maximum based on meeting or exceeding stated targets. A taxable event occurs once the metrics are satisfied and the shares are delivered. The value is taxed as ordinary income.

5. Stock Appreciation Rights (SARs)

SARs often look and feel like NQSOs. However, they differ because they give you, the employee, the right to any increased stock value above a set SAR strike price, multiplied by a designated number of shares. Depending on the terms of your agreement, the value of the SARs at exercise may be delivered in cash or shares of stock. At exercise, a taxable event occurs, taxed as ordinary income.

What is the Value of Your Equity Compensation?

Determining the value of your equity compensation can be simple and complicated at the same time. Once you understand what type of equity you are dealing with, you can approximate its current and potential value. That said, these estimates may not best capture the true range of possibilities. For example, depending on how the future unfolds, a stock option can end up being worth multimillions of dollars … or $0.

Starting Simple

Beginning with the simple, you can estimate the current value of your equity compensation as follows:

  • RSUs: The value equals the number of units multiplied by the current share price.
  • Stock Options: The value equals the prevailing stock price minus the option’s strike price.
  • SARs: The value equals the prevailing stock price, minus the SAR strike price.
  • Performance Shares: Like RSUs, the value equals the prevailing market price of the stock multiplied by the number of performance awards. However, this can be complicated by how many shares you should include based on your minimum, target, or maximum threshold.
  • Long Shares: Long shares are stock shares owned outright. They can result from vested and held RSUs, or exercised and held employee stock options. Long-share value equals the stock price multiplied by the number of shares.

Complicating Considerations

The above estimates are a good first step. But for improved personal financial and tax-planning projections, you may also want to consider how a range of variables factor into the equation.

Vested vs. Unvested: First, there’s vested vs. unvested values. Beyond the simple values described above, it’s important to consider which type of equity can be actioned (because they’re already vested) and which are merely promises of future value (because they’re still unvested).

For example:

  • RSUs: Prior vested RSUs, if unsold, may simply be shares of stock that you own and can sell as you wish (assuming no other restrictions). Unvested RSUs generally remain a future promise. Whether you own shares of stock or have unvested and undelivered RSUs, the value of the equity changes in unison with the changing stock price.
  • Employee Stock Options: Stock options can be both unvested (and unactionable) or vested and unexercised (you can exercise, but are not required to). Once you exercise an option, it becomes a stock share you own outright, which you can hold or sell.

Clearly, whether your equity compensation is vested or unvested can impact how much you may depend on its value.

Peering into the Unknown: Whether you’re holding equity compensation before or after vesting, it would be nice to know for sure what its future value may be. Unfortunately, this is impossible. However, one formula used to guess at its expected value is the Black-Scholes Pricing Model. Established in 1973, this model, like any other, cannot predict the future. But it has become a widely accepted method for identifying expected values under various assumptions. As we described in our post “6 Reasons to Exercise Your ISOs When the Price Is Down,”

“The Black Scholes Model gives us a way to at least approximate potential future value. This model uses facts such as the risk-free rate, price volatility of the stock, and time to expiration to determine what your future value may be.”

What does Concentration Risk Have to Do With It?

Knowing the current value and estimating the future value of your equity plays an important role in helping you decide how much single-stock concentration risk you have and want to take on as you proceed.

How much of your net worth do you want to tie to a single stock, especially your employer’s stock? If your modeling suggests your equity compensation represents too great of a stake in your net worth, this is an important thing to know.

If even a worst-case valuation of your equity compensation won’t ruin you, you may decide to take on the concentration risk anyway, in pursuit of a potentially greater reward. If, on the other hand, the valuation reveals you’d be risking too great a percentage of your net worth, you may take a more cautious approach. If you’re looking for a benchmark, one rule of thumb suggests that you may be exposed to too much concentration risk if you hold more than 10-15% of your net worth in a single stock position.

Closing Thoughts on Equity Compensation

Equity compensation can be a valuable tool for generating considerable wealth. However, it can also be complicated and confusing due to tax implications, trading decisions, and risk/reward tradeoffs. If you’re offered a menu of equity compensation benefits, which should you choose? Upon vesting, how should you proceed? When should you exercise your options? When should you sell exercised shares? We hope today’s overview will help you get started. If you find yourself with a meaningful equity compensation package, it’s also often wise to consult with a financial advisor and/or tax specialist as you proceed, to help you make the most of this potentially highly rewarding employee benefit.

 

This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product.The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation.

Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value.

Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results.

Talk to your financial advisor before making any investing decisions.

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Hi, I'm Daniel Zajac, CFP®, EA

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I write about equity compensation and employee stock options in a way that is easy to understand.

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