How Can I Understand My Equity Compensation?

If you are fortunate enough to be eligible for equity compensation, your initial reaction may be a combination of happiness and confusion.

Here's a basic primer on what is equity compensation, so you'll understand exactly what you're being offered.  Additionally, included here are the types of equity compensation you must know. 

Stock options 

Your employer may grant you an option to buy a designated number of shares at a stated price over a certain period or when specific performance metrics are met.  The employer can specify a vesting schedule, like 10% a year over 10 years.

As the grantee of these options, you benefit from the difference between the exercise price (the price at which you can buy the shares) and the market price (the stock price at the time you exercise your options).

Non-qualified stock options are taxed at ordinary income rates on the difference between what you paid and the stock market value on the date of exercise.  Non-qualified stock options can be granted to employees and non-employees.

Incentive stock options (also known as qualified stock options) can only be granted to employees. 

These options can qualify for favorable tax treatment, potentially permitting long-term capital gains rates to apply if you hold shares for one year from the date of exercise and two years from the date of the grant.  There are other requirements to qualify for favorable tax treatment as well. 

Employee stock purchase plans (ESPPs)

An employee stock purchase plan (ESPP) permits employees to buy company stock, typically at a discount.  You contribute to the ESPP with deductions from your salary.  On designated dates, the company uses the funds in the ESPP to buy shares for eligible employees at a discount.

If you are participating in a qualified section 423 ESPP and hold the shares for more than two years after the grant and more than one year after purchase upon sale, the difference between what you paid and your proceeds will be taxed at long-term capital gains rates. 

A non-qualified ESPP may offer a higher discount than a qualified ESPP or share matching by the employer.  

With a non-qualified ESPP, you are taxed at ordinary income rates on the difference between the fair market value of the stock and the amount you paid.

Restricted Stock Units

Restricted Stock Units are grants of company shares from your employer to you, often pursuant to a vesting schedule, and at no cost.  The vesting schedule can be based on designated periods or performance metrics.  You can't sell your shares until you've met the vesting conditions.

Typically, vesting terminates if you leave the employ of the company.

You will be taxed at ordinary income rates based on the value of the shares on the date of vesting or delivery.

Restricted stock awards

A Restricted Stock Award (RSA) gives you the right to buy shares at fair market value, at no cost, or at a discount.  While the grant of the shares is immediate, you only earn the right to keep the shares by meeting certain vesting conditions.  You own the actual shares from the time of the grant.  

If you make an 83(b) election, you are taxed on the value of your shares on the date of delivery as compensation income rather than the value of the shares when the vesting conditions are met. 

SUMMARY

Calculating the value of equity compensation can be challenging.  Unlike salary, the value of equity compensation can fluctuate.  Tax issues relating to equity compensation can be complex, making it prudent to consult with tax, legal, and finance professionals.

The primary risk of stock options is the possibility that your option price will be higher than the market price for the shares on the date of vesting.  If this occurs, the value of your stock options will be zero.

Employee Stock Purchase Plans carry a similar risk.  Even though you are buying the stock at a discount from market price, there's no guarantee the price of those shares will increase in value over time.  It's possible the value of your holdings will be less than the market price of the stock when you wish to sell.

Restricted Stocks Units are low risk.  They cost you nothing.  You aren't taxed until you receive the shares, based on the value of those shares at that time.

The risk of Restricted Stock Awards varies depending on the terms of the offer.  If you are awarded the shares at no cost or a substantial discount, your risk is lowered.  However, since you are taxed at the time of purchase on the difference between fair market value and your cost, if the shares subsequently decline in value to a point below your cost, you will incur a loss.

The "best" type of equity compensation depends on factors you may have limited control, like the future value of the underlying stock. If you are undecided on which option works best for you, avail yourself of financial advisory services today. 

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