Companies use more than just a salary to pay their employees and Equity Compensation is one of those ways!
Equity compensation in essence is being paid in the form of shares or stock of your company. It’s a way for you to participate in the growth of the company and gives employees an incentive to produce results. You could call it a Win-Win for both you and your employer.
Understanding your Equity Compensation is a MUST! And I’m going to break it down for you:
The Basics
To reiterate, equity compensation is another way for you to be compensated for your work that you do for your company.
It’s often used by companies to:
- Allow you to participate in ownership of the company (and potential GROWTH)
- Align your work and vision with your employers’ goals and vision
- Reduce need for company to pay only in cash (maybe they need this cash for investment elsewhere)
If you’re receiving equity compensation, Awesome! It’s important to understand a few key phrases or words that your plan will use:
Grant Date
The date in which you have been granted (awarded) your company stock
Vesting schedule
It’s the schedule in which unvested shares will become vested, giving you the ability to exercise and take control of these shares (more to come on this)
Vested shares
This means you now have full ownership of the shares you were granted!
Un-vested Shares
These are shares that have been granted to you, but are not currently under your ownership and may have to meet certain requirements and/or vesting schedule for your full control.
Exercise Price/Strike Price
Some plans offer you the right to buy shares at a certain price at a certain date in the future. This price is known as the exercise price.
You now have the basics. Next, let’s look into the most common types of Equity Compensation plans you may be enrolled in. Chances are, you will be enrolled in one of the next 4 plans:
Restricted Stock Units (RSU’s)
Restricted stock units are when a company grants you a specific number of shares that generally vest over a period of time. Here’s an example of a company granting you 1000 shares vesting over 4 years:
Grant Date: 1/1/2023
Vesting Schedule:
1/1/2024 = 200 shares
1/1/2025 = 200 shares
1/1/2026 = 200 shares
1/1/2027 = 400 shares
There’s not much an employee can do with these shares until they vest. Upon vesting, the owner will pay income tax on the value of the shares that vested.
Once the shares vest, they are in full control of you the employee, and you can do what you wish with the shares: Sell, hold etc.
Restricted stock units are arguably the most common type of equity compensation and are very straight-forward once you understand the basics.
Incentive Stock Options (ISO’s)
Incentive stock options are another company form of equity compensation your company may use. Instead of receiving shares over the vesting schedule, Incentive stock options give you the right to purchase shares at a specific price, during a specific window.
Here’s an example:
Grant Date: 1/1/2023
1000 shares at $30
Vesting Date: 1/1/2025
Expiry Date: 1/1/2035
Couple things here, the first being that once the ISO’s vest, nothing happens until the employee decides to purchase the shares. The employee has a window to purchase the 1000 shares at $30 during a 10 year window (in this example). This stock plan requires the employee to make a decision to purchase the stock, to hold onto the options until a later date, or to let them expire. Ideally the employee is able to purchase the shares during the window at a lower price than what the company stock is trading for. Here’s an example:
Current stock price: $45
Offer Price: $30
You can see here that the employee can buy 1000 shares for $30 a piece, while the underlying stock price is currently trading at $45. ($15 dollar difference, Woo!)
ISO’s can have great tax advantages too if worked correctly. If they meet a certain holding period (2 years since grant date, and 1 year since exercise date). If the shares are sold after this period, the seller will only pay capital gains tax (More on ISO’s in another blog post).
Non-qualified Stock Options (NQSO’s)
Non-qualified stock options are very similar to Incentive stock options with one slight difference. The difference being that the employee once exercising their stock, will pay income tax on the difference between the exercise price and the grant price. Here’s an example:
1000 shares
Grant price: $30
Current Market Value: $45
Assume the employees’ shares have vested and they purchase the 1000 shares. The employee will pay tax on the difference between $45 and $30 ($15 difference)
= Income tax on $15,000 (1000 shares X $15)
Once you have the shares in your possession, normal holding rules apply. Again, more on this in a separate blog post.
Employee Stock Purchase Plan (ESPP’s)
Lastly we come to the Employee Stock Purchase Plan. A plan that on the surface looks easy to understand, but can cause some headaches trying to maximize this type of plan.
At it’s core, the Employee stock purchase plan is a way to use payroll deductions to buy your company stock at a discount. Let’s take a look:
Offer Date: 1/1/2023
Purchase Date 4/1/2023
Discount = 15%
The offer date is when employees can begin to contribute some of their salary to be put away to purchase shares on the purchase date. We can also see here that the discount is 15%, meaning that the plan will purchase company shares at a 15% discount on the purchase date.
Let’s say the stock price on the purchase date is $100 and you have saved $850 in payroll deductions in your plan to go towards purchasing stock.
One the purchase date, the company purchase 10 shares (current market value – 15% = $85 per share).
Tax wise, you will owe taxes when you sell the stock and can be either income tax or capital gains tax, depending on when you sell it. Some company’s will also require a holding period for the stock once you purchase.
So there you have it. Equity Compensation can be an amazing tool to help you build wealth, but are often head scratchers, which is why many shy away from utilizing them fully.
Once you start to understand the details of your plan, including taxation and how to maximize it, they are a great tool for you and your family.
If you need help understanding your plan and how to best utilize your equity compensation, feel free to reach out below!