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An Introduction to Equity Compensation
July 29, 2021 | By Brant Cavagnaro, CFA®, CFP®
For executives at public companies and key employees of early-stage startups, it’s common for companies to offer equity compensation in place of a higher salary. In this blog post, I’ll explain what equity compensation is and discuss the differences between each form of equity compensation.
What is Equity Compensation?
Equity compensation refers to various forms of non-cash pay that are offered to employees. In many cases, employees take less base salary in exchange for equity compensation. The two most common forms of equity compensation are stock options (both non-qualified and incentive) and restricted stock (awards or units).
Equity compensation is common in mature, publicly traded companies as a way to incentivize executives and valuable employees to stay with the company for a long period of time and work toward achieving key performance metrics. Startups (especially tech startups) with limited capital also use equity compensation to attract and retain employees with the promise of potentially sharing in future profits.
Types of Equity Compensation
Non-Qualified Stock Options Stock options give you the right to purchase shares of a company stock at a set price at any time over a specified period. The price of the option (known as the strike price) is often the stock’s fair market value on the date the option is issued. Options are given an exercise window when issued, which is the period of time you have the option to purchase the stock.
If the stock price appreciates and you exercise your option, the difference between the strike price and the exercise price is called the spread. The spread on non-qualified stock options is taxed as ordinary income. At the time of exercising the options, any additional stock appreciation after exercise is subject to short or long term capital gains depending on how long the stock is held.
Incentive Stock Options Incentive stock options (ISOs) have a few key differences compared to non-qualified stock options. Unlike non-qualified stock options, ISOs are not taxed when they’re exercised. If you hold on to the stocks for over a year after they’re exercised and at least two years after the option is granted, you’ll be taxed as long-term capital gains when selling the shares. Although you are not taxed on the exercise initially, the spread is considered an add back item for alternative minimum tax (AMT) purposes. It is important to speak with your accountant and financial advisor to determine if you will be subject to AMT as a result of exercising.
Restricted Stock Units Restricted stock units (RSUs) are not actually stocks, but a promise to issue shares of stock after certain conditions are met. Shares are often issued after a specific window of time or vesting period. In some cases, RSUs can require that you meet set performance metrics before they vest. If you have restricted stock units, you also won’t be given voting rights or dividends until after they vest. RSUs are taxed as ordinary income upon vesting and subject to capital gains thereafter.
Restricted Stock Awards The key difference between restricted stock awards (RSAs) and RSUs is that you own the shares on the day the restricted stock is granted and are potentially eligible for dividends. Unlike with RSUs, owners of RSAs have the ability to make an 83(b) election, which could potentially result in huge tax savings. An 83(b) election allows you to pay taxes on the grant value even though the stock is unvested. Additional appreciation in the future would potentially be subject to the more favorable long term capital gains rate. The downside is if the stock price falls after granting, you essentially prepaid taxes on a higher value than what you receive at vesting.
Stock Options vs. Restricted Stock Unlike options, RSAs and RSUs are known as full-value awards because you never actually have to pay for them. If you’re issued a stock option and the market price never goes above the strike price, you’d choose not to exercise your option and the option would become worthless. On the other hand, if you’re awarded restricted stock, your award will almost always have value.
Key Considerations When considering whether to accept equity compensation in lieu of a higher salary or a salary raise, it’s crucial to look at the big picture. Here are a few questions to consider:
How would holding substantial stock in this company fit with my overall financial goals?
How will this impact my tax outlook in the short-term and long-term future?
What is the vesting window? How long will I be tied to the company?
Equity compensation can come with risks, but the potential upsides are also significant. Since it affects both your income and your portfolio, discussing your options with a financial advisor—both before and after you accept an equity compensation package—can help you stay the course and remain confident in your financial decisions moving forward.
Still have questions about equity compensation? The Wealthstream Guide to Equity Compensation clarifies key terms, helps you navigate your paperwork, and provides suggestions given your circumstances. Download the white paper here.