Smart Money Tips

What is Equity Compensation?

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To put it simply: equity compensation is being paid in company stock in addition to, or in place of, base salary.

Equity Compensation

When start-ups and small businesses can’t match the salaries of the big guys, but they still want to entice sought-after candidates, equity compensation plays a vital role; it supplements below-market salaries.

Equity compensation is non-cash pay that can be comprised of investment vehicles like restricted stock, options, and performance shares; and they all indicate an employee’s partial ownership of the company. Offering employees a stake in the company can also encourage them to work harder, as they benefit from the company’s success.

Understanding Equity Compensation

If your offer includes equity compensation, you first need to be familiar with the investment vehicles it includes to properly assess your offer. Grab a beverage, and let’s break them down.

Stock Options

Stock options allow employees to purchase shares of company stock at a set price (called a strike price, grant price, or an exercise price) for a defined number of years. Options vest after an allotted amount of time, meaning you can exercise your stock: buy, sell, or transfer it. Vesting refers to the process of earning full rights to an employer-provided asset, and it normally does not exceed four years.

However, most Employee Stock Options (ESO) cannot be sold, unlike standard options. Instead, when the price of the stock exceeds the exercise price, you can exercise – buy – the stock if it is vested. And this is the ideal scenario; you’re buying the stock at a lower price than the market value. This “spread” equates to an average of 12-20% of an employee’s base salary.

But what happens if the stock value has decreased? Companies are legally allowed to reprice options for employees. So, if the exercise price was $35 and the market value drops to $25, they can cancel the initial option and offer new ones at the new price of $25. This practice, however, is not favored by outside investors.

Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs)

Non-Qualified stock options and incentive stock options are additional forms of equity compensation with specific tax advantages. NSOs, like typical stock options, allow employees to buy shares of stock at the exercise price for a limited amount of time. However, you do not have to report NSOs to the IRS until you decide to exercise the stocks; at that point, you would pay income tax on the gain, or the difference between the exercise price and the market price. This tax scheme allows you to exercise your stocks when it’s most advantageous for your financial situation.

Incentive stock options are similar to NSOs but with added tax breaks. Unlike NSOs, there is no income tax owed to the IRS when you exercise. Additionally, you can avoid paying regular income tax on the options and instead pay the lower-rate capital gains tax. And here’s an example of how: you are granted ISOs in March 2019, and you exercise them in March 2020. To qualify for the special holding period, you must hold the ISOs until March 2021. Simply put, you are enabled to pay capital gains two years after the options are granted, and one year after they are exercised.

Restricted Stock Units

The most common type of equity compensation, restricted stock units (RSUs), are offered when a company has a stable valuation or goes public. Similar to stock options, they vest over time, but you don’t have to buy them. Therefore, RSUs have less risk while enticing employees to stick around for their assets to vest. And once they vest, there are few limitations – it’s as if you bought the shares on the open market.

However, the term “restricted” is operative. RSU holders of vested shares do not have voting rights and the shares are not transferrable. It also refers to the vesting schedule which may be defined by a length of time, performance goals, or other terms of employment.

Equity compensation is slightly more abstract than the US dollar because the share value is much more volatile. However, whenever you make financial plans, include assessments and projections of your total compensation to give yourself a more holistic picture of your financial situation. Don’t leave money (or shares) on the table because you didn’t look at the big picture.

Need help creating a financial plan that accounts for equity compensation? Contact Archer Investment Management – the go-to financial advisor for Austin’s tech workers.