Stock, Stock Units & Stock Options . . . Oh My!
Among the myriad of challenges associated with starting a new career, deciphering your compensation package may top the list. For military veterans who come from a world of standardized payrates, understanding the compensation offered by their new civilian career can be confusing. For veterans who find their strong technical background and team-focused leadership opens doors at technology driven startup companies, understanding their compensation can be even more challenging.
Transitioning to work in these innovative companies can provide incredible opportunities to employ both their technical and creative skillsets. As icing on the cake, these fledgling companies frequently sweeten their employees’ compensation with the opportunity to own a portion of the company. Beyond straight up salary, vets who transition into tech companies find their pay includes complex equity-based compensation.
In our tech driven economy, the competition for highly skilled employees can be steep requiring companies to offer substantial compensation packages to attract employees and incentives to retain them.
The first step to understanding equity-based compensation is to understand what it is and why companies offer it. At its most basic level, equity-based compensation is simply a way for a company to pay a portion an employee’s salary in the form of ownership in the company. This ownership is known as equity.
In the tech and startup community, equity in the form of actual shares of the company or options to purchase shares at a discount, can make up one-third to one-half of an employee’s compensation package. While not yielding an immediate cash benefit, equity compensation has the potential to generate substantial rewards if the company grows in value.
Why do companies pay equity compensation?
The motivation for companies to pay employees with ownership typically centers around two main themes: attracting and retaining the most capable employees and aligning the employee’s motivations with the company’s own.
For many cash-strapped start-up companies, their ability to attract the best and brightest with pure salary is limited. In exchange for more modest salaries, startups offer early employees equity-based compensation that has the potential to generate substantial wealth if the company succeeds in their innovative endeavors.
Beyond attracting and retaining employees, ownership in the company centers the employee’s focus on the company’s mission by aligning their goals with the company’s: the more successful the company, the more valuable their equity.
Employee retention goals are met by staggering the award of equity over three or four years, enticing employees to stick around long enough to earn the full potential of their equity. If the employee leaves the company before meeting the established timeline, they forfeit a portion of their equity.
Vesting Schedule. This time-based delivery is known as a vesting schedule, whereby a portion of the employee’s equity is earned when specific company goals are achieved or when a specific timeline is met. A typical vesting schedule stretches the equity award proportionately over four years, with one-fourth awarded to the employee each year.
Stock, stock units, and stock options.
Equity in a company typically comes in the form of either stock, stock units, or options to purchase stock at a reduced price. Which type of equity an employee earns largely depends on whether the company is a private company or a public company. Public companies, those that trade publicly on one of the major stock exchanges, primarily incentivize employees with restricted stock units and/or employee stock purchase plans.
Private companies, those that are privately owned with the potential to grow into public companies, primarily compensate their employees with options to purchase stock at substantially reduced prices or occasionally, in the case of very young start-ups, with restricted stock awards.
Equity compensation at publicly traded companies is more straightforward than equity in a private company primarily because a public company has a known market value and immediate liquidity.
Public company equity compensation
Restricted Stock Units. Restricted stock units, known as RSUs, are awarded to employees as a promise to exchange each stock unit for a share of stock at a future date. RSUs are considered the most straightforward form of equity compensation.
Based on a vesting schedule, the employee earns a portion of the RSUs each year, each quarter, or even monthly. Because RSUs are awarded by public companies, the shares have market value, giving the employee the benefit of immediate liquidity. This liquidity makes RSUs behave like a cash bonus awarded proportionately over the course of several years.
As an example, an employee might receive an initial grant of 1000 RSUs with a four-year vesting schedule. At the end of the first year, one fourth of the RSUs vest giving the employee 250 shares of company stock. The employee can either sell the shares for cash or hold them in a brokerage account with the hopes that they will continue to appreciate. Over the next three years, the employee vests the remaining portions of the initial grant of RSUs.
Employee Stock Purchase Plans. Another form of equity compensation found at public companies is employee stock purchase plans (ESPPs). These plans allow an employee to purchase company stock at up to a fifteen percent discount with after-tax payroll deductions. The employee is permitted to use up to $25,000 of salary per year to purchase shares directly from the company, typically at a three or six-month interval.
An example of an ESPP would be an employee who participates in the plan by agreeing to set aside ten percent of her salary each paycheck to purchase shares of company stock. At the end of six months, this money is used to purchase shares of stock at a price 15% below market value. Depending on the details of the company’s ESPP, she may be required to hold onto these shares for a specified time period before selling them in the open market or she might be permitted to sell them immediately for a fifteen-percent profit.
If the ESPP includes a “lookback” provision, the equity plan can prove even more beneficial. A lookback provision applies the discount to the market value at either the first day or the last day of the offering period, whichever is lower. Looking back to the price on the first day frequently nets an even lower base price on which to apply the 15% discount generating even greater gains in value.
Private company equity compensation
Equity-based compensation for employees who work at a private company differs from that of public companies because the company’s stock is not yet available to trade in a public stock market like the New York Stock Exchange. Equity granted by startups before the company progresses from private to public company typically comes in the form of either employee stock options or restricted stock awards.
Employee Stock Options. The most common form of equity-based compensation at private companies is known as employee stock options which grant the employee the option to purchase a specific number of shares at a price known as a strike price within a particular time frame referred to as an exercise window. By exercising the option to purchase shares of stock at a low strike price, the employee has the opportunity to participate in the growing value of the company, with the goal of selling the stock at a greatly increased value once the company becomes public.
By way of example, let say an employee at a small tech startup receives a grant of 1000 shares of company XYZ with a strike price of $2 and a four-year vesting schedule like the one in our previous example. At the end of their first year of employment, the first one-fourth of the grant vests, giving the employee the option, but not the obligation, to purchase 250 shares of XYZ stock at the $2 per share strike price.
If the current estimated value of the stock is $4, it could be financially beneficial for this employee to exercise their options at the lower strike price of $2 per share, locking in their ownership with a $2 per share increase. Since the company is not yet publicly listed, the employee cannot immediately sell these shares. They will need to hold on to the shares in hopes that once the company becomes publicly traded, the value of the shares will increase, earning an additional gain when they eventually sell the shares.
Eye-sos and Non-Quals. Employee stock options come in two main forms based on when and how they are taxed by the IRS. (Taxes on equity compensation is complicated, we’ll dig deeper into taxes in a future blog.) The two types of employee stock options are known as incentive stock options (ISOs) and non-qualified stock options (NSOs).
ISOs qualify for a more favorable tax treatment when specific timelines are met between when the options are granted, exercised and sold. When these IRS timelines are met, the proceeds from ISOs are taxes as long-term capital gains rather than ordinary income tax. This favorable tax treatment make ISOs more complicated, but potentially more lucrative, since the capital gains tax rate is typically lower than the ordinary income tax rate.
Non-quals or NSOs are known as non-qualified stock options simply because they do not qualify for the IRS’ preferential tax treatment. Profits generated by these options are taxed as ordinary income.
Restricted stock. This type of equity is typically awarded to very early employees and to C-suite executives of private companies. Restricted stock awards tie an employee’s compensation directly to company performance. In the case of very early employees, the value of these shares can grow substantially over the life cycle of a start up company.
As an example, a very early employee of company ABC receives a restricted stock award of 1000 shares valued at $0.50 each. Seven years later when ABC is listed as a public company the shares trade at $10.00; earning the employee a $9.50/share gain in value.
An important step in understanding the equity portion of your compensation is to know that it will add a layer of complexity to your income, your investment portfolio, and your tax obligations.
Got equity?
Because equity compensation is unique to each company, it can vary greatly between companies and even between employees, depending on when they were hired and which type of equity they received.
If your compensation package includes equity, the first question to answer is what type of equity did you receive? Then you’ll want to understand the vesting schedule and any time or performance related restrictions. Armed with these details you’ll be better prepared to understand the investment and tax implications of your compensation and any vesting requirements that might impact your employment decisions moving forward.
Next, it is important to remember that equity compensation is taxable income and except for ISOs, is taxed as ordinary income including employment taxes such as Medicare and Social Security taxes. In the case of ISOs, achieving the more favorable capital gains tax rate requires adherence to strict timelines and potentially exposes the employee to the alternative minimum tax (AMT).
It’s also paramount to appreciate the potential value of your equity compensation. Depending on the success of the company, equity compensation has the potential to generate life changing wealth. Early employees at Google, Slack and Airbnb are beneficiaries of the amazing potential of equity-based compensation. But it’s important to be realistic, they’re called unicorns for a reason. The road from private to public can be bumpy; historically, only thirty percent of startups have a successful exit either through acquisition or a public listing and only one-percent experience exponential growth.
In addition to delivering amazing new opportunities, equity-based compensation may bring a host of decisions around diversification.
Diversification becomes critical when both your job and your net worth are tied to the same company. Because equity compensation can amplify your investment in a single company overnight, you may quickly find yourself in the position of having almost all your net worth tied to your employer. Because it’s never a good idea to have all your eggs in one basket, you’ll want to develop a plan to proactively divest your company stock to reduce the risk inherent in investing in a single stock.
Here’s where it gets interesting. The decision to divest your equity investment requires you to balance competing goals. On the one hand, you’re a loyal employee and have invested your time and talent into the company’s success and growth. You want to ride the company rocket ship all the way to the top. This emotional tie is real and must weigh against the need to make rationale investment decisions within a complicated framework of taxes and often strict compliance restrictions on when and how much of your stock you’re permitted to sell.
Integrating these competing motivations into a thoughtful plan to accomplish your investment goals can be challenging. Working with a financial planner who understands the complexities of equity compensation and the resulting diversification, tax and compliance restrictions can help you develop a thoughtful strategy to optimize this incredible financial opportunity.
If you’re ready to unravel the complexities of your equity-based compensation, we’d love to work with you. To learn more about working with Tailwind Financial Planning, please schedule an introductory call.
