Your Guide To Equity Compensation

October 2, 2022

Equity compensation comes in many different forms. From those that work in the oil & energy industry to tech companies and beyond, equity compensation is a valuable form of non-cash pay. Because of the complexities involved, it’s important to know the mechanics and especially the impact of taxes.

In this post, I will breakdown the nuts and bolts of equity compensation so you can be informed and maximize your money.

What Is Equity Compensation?

Equity compensation is a payment in the form of equity instead of cash. If you are offered equity compensation, you are actually receiving the option or ability to buy stock in the future. This allows the employee to have ownership in the company and participate in profits. These different forms of equity compensation will be explained further in this post.

Equity compensation can be used by both private and public companies. Why do companies offer equity instead of cash? For startup firms, they want to hire top talent at a time when cash flow might be limited. In this case, equity is a good supplement over cash and might offer more potential upside. Larger corporations, such as big oil & energy firms and other public companies, use this to incentivize and retain employees. In order to keep employees at the company, a common trait is something called a vesting schedule, which I will discuss next.

What Is A Vesting Schedule?

You typically don’t receive stock in the company on the first day. Rather, you have to wait and earn shares through a vesting schedule over a period of time. This restricts your access to the shares until this period of time has passed. Vesting schedules can vary by company, but in the majority of cases, this occurs in time-based increments.

Restricted stock and stock options are almost always subject to a vesting schedule. Vesting commonly occurs on specific dates, such as monthly, quarterly, or annual schedules. Vesting can also occur based on performance metrics. It’s important to know the specific vesting schedule of your equity compensation. Which can be found in your company agreements.

If you quit before the end of the vesting period, you typically forfeit what has not vested. What types of equity compensation can you have? Let’s talk about that next.

Types Of Equity Compensation

Equity compensation comes in different forms. Understanding this is important in making the decisions necessary to maximize your money. You may also have the ability to choose a type of equity compensation or receive more than one based on your benefits package.

Stock Options

Stock options give the holder, or who they were granted to, the right to purchase shares of stock at some date in the future. There are two different types of options — Incentive and non-qualified stock options. What’s the difference?

Incentive stock options

This option is only granted to employees of a company. It gives you the right to purchase company stock at an exercise price. One thing to remember with stock options is that you have the “option” to purchase stock, but not required to do so. Once the vesting period has ended, you have the option to exercise and buy the stock.

Where ISO’s can get tricky is taxation. Incentive stock options are not taxed until you sell the stock, as long as the stock is held for one year after exercise and two years after they were granted. In this case, when you sell the stock, you’ll pay capital gains tax rates.

To add some additional complexity to taxes, if you don’t sell the stock in the same year of exercise, you may be subject to an alternative minimum tax, or AMT. The reason for this is the tax break that ISO’s offer.

Non-qualified stock options

Unlike an incentive stock option, non-qualified stock options are typically granted to those not employed by a company. This includes contractors and consultants. Non-qualified stock options do not have a preferential tax treatment. This means the taxation is a little more simplified as you are taxed at your income tax rate when the option is exercised. Regardless if you hold the stock or sell it after exercise. If you continue to hold the stock for one year and a day, you’ll pay capital gains tax rates.

Restricted Stock Units (RSU)

Restricted stock units are more simple to understand than stock options. Here is a basic refresher on what you need to know when it comes to RSUs. This form of equity compensation represents a future promise to the employee in the form of company shares. The nice thing about RSUs is that they will always carry a value, unlike stock options that can be underwater if the stock price drops below the option exercise price.

RSUs follow a vesting period in which the shares become yours after this period of time has passed. Upon the vesting period, this becomes taxable income based on the stock price at vesting. Don’t let the simplicity of RSUs let you look past some strategies to deploy to save money on taxes! Here are five RSU strategies to consider.

Employee Stock Purchase Plan (ESPP)

An employee stock purchase plan is one of the best benefits of a compensation package. It’s like getting free money! An ESPP allows employees to purchase company shares at a discounted price over a certain period of time. This discount on the shares in essentially free money. The money to purchase these shares is deducted from your paycheck.

An ESPP is a little different than the other forms of equity compensation. There is no grant to an employee, rather it’s a benefit that an employee chooses to participate in. It doesn’t follow the typical vesting period like other equity compensation but does have some important dates to know. Here is a good intro to employee stock purchase plans that covers the nuts and bolts.

Equity Compensation Timeline

There are many terms when it comes to equity compensation, especially with stock options. You will see these terms in your company agreements along with the dates and prices associated with each one. These serve as a valuable timeline and help you plan a course of action with your equity compensation.

Grant Date: This is the date that you receive the granted option.

Vesting Date: The date on which the options vest and you can exercise. In the case of restricted stock, this is the date the stock is yours.

Exercise Price: The price you exercise your options at. This is a predetermined price based on your stock option agreement.

Expiration Date: The date you must exercise your option by, or else they can expire. This is typically many years after the option grant.

Equity compensation can be an incredible perk to building future wealth. It’s important to understand the mechanics of how equity compensation works and more importantly how it fits into your financial plan. You want to make sure you have a proactive plan in place before taking action on your equity compensation. Be sure to work with a trusted CERTIFIED FINANCIAL PLANNER™ to help make important decisions while also minimizing your exposure to taxes. If you want to have a conversation about your equity compensation, let’s chat!

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