- Many companies offer shares of their stock as an incentive and reward to employees
- There are two ways to think about equity compensation: as a bonus or as an investment
- There are two major types of equity compensation: shares you’re given and shares you have the option to purchase
- There are laws governing equity compensation plans, but every company’s plan is different
- There are many terms you need to understand before exercising your stock options
- Taxes vary widely for different forms of equity compensation
Companies are increasingly offering equity compensation in their employee benefit packages. And it’s not just the large companies, either. Even some private businesses that don’t have company stock available to the public are doing it.
But what is equity compensation? For publicly-traded companies, it’s company stock issued to employees. For private companies, it’s the option to purchase shares at a certain price.
Behind those simple statements is a complex web of financial decisions and tax laws that can vary widely. It all depends on the type of equity compensation, your financial situation, and your plan.
If your employer offers equity compensation, here’s how to take full advantage so you don’t leave money on the table.
How does equity compensation work?
Equity-based compensation is non-cash compensation that gives employees an ownership stake in the company. Unlike salaries, which are guaranteed and immediate payments, equity-based compensation is often conditional. It is given to employees as part of their overall compensation package and can be received immediately or after surpassing certain milestones. Over time, when a company’s stock price appreciates, shareholder value also increases.
Why do employers offer equity compensation?
Employers offer equity compensation to attract new hires and retain and motivate employees. Offering employees an ownership stake in the company aligns their incentives with the company’s goals, fueling both individual and organizational growth.
Equity compensation is a compelling tool to entice talent in the competitive landscape of the tech industry and startups. Offering a stake in potential future success can offset lower initial salaries, making these offers attractive for potential employees.
Moreover, by substituting traditional cash bonuses with equity bonuses and providing compensation in the form of ownership, businesses can retain more cash to fund operations and growth initiatives.
Two ways to think about equity compensation
Although there are several different types of equity compensation, your decisions about how to manage yours begin with one fundamental question: Do you want to treat your equity compensation as a cash or investment bonus?
If you see it as a bonus, you may want to sell the stock soon after acquiring it. In that case, you’ll want to calculate the best way to make the most of your money, taking into account the taxes you’ll owe. The taxes can vary widely depending on how long you hold your stock.
If you see equity compensation as an investment, consider how much of your financial future is tied to your company’s stock.
Although this decision will vary for everyone, it’s recommended that no more than 5-10% of your investment portfolio be concentrated in a single company’s stock.
Types of equity compensation plans
There are several types of equity compensation, but they all work in one of two ways.
The first type is simple.
You’re given shares of company stock at no cost on a specific date. This would be very similar to a cash bonus, except instead of getting $5,000 in cash, you’re receiving $5,000 worth of company stock. This should be spelled out in a stock agreement separate from your contract or employment agreement.
The second type is when you can buy a certain number of shares of your company’s stock at a specific price on a certain date.
You don’t own the shares until you buy them. Your company might tell you that you can buy up to 500 shares of its stock at $25 as of June 1 (the strike price). If the stock is worth more than $25, you’ll be able to buy it at a discount (a big perk).
Because this is an option, you can buy fewer shares or none at all. It’s entirely up to you. Unless you leave the company, you typically have ten years to exercise that option, but check with your employer to make sure. You can usually wait until the value of the shares is above your purchase price.
What's a strike price?
The strike price is the amount you'll pay to purchase one share of your company when you exercise a stock option.
Here are the most common types of equity compensation plans, each with its own unique characteristics and benefits.
- Incentive and Non-qualified stock options (ISOs & NSOs)
- Restricted stock awards (RSAs) and restricted stock units (RSUs)
- Employee stock purchase plans (ESPPs)
ISOs and NSOs
There are two main categories of stock options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs).
ISOs offer tax benefits under certain conditions, whereas NSOs are taxed differently and have fewer restrictions.
For instance, ISOs may trigger the Alternative Minimum Tax (AMT) if the Fair Market Value (FMV) at exercise is higher than the strike price. Yet if sold after holding for a year, gains are subject to the lower long-term capital gains tax.
On the other hand, NSOs are taxed as ordinary income based on the difference between the stock’s FMV at exercise and the strike price. Federal, Medicare, FICA, and state taxes apply.
Restricted stock awards (RSAs) and restricted stock units (RSUs)
A restricted stock award (RSA) grants company stock with restrictions. The employee owns the shares when accepting the grant and meeting purchase price requirements, but they will still be subject to vesting conditions. The shares are restricted from being traded or transferred. This restriction allows the company to stay in compliance with securities laws.
RSUs are agreements to issue employees shares of stock or the cash value of shares in the future. Each unit is worth one share or its cash value. RSUs are subject to vesting schedules or performance goals, which may be tied to various company performance metrics.
Upon vesting, RSU holders have the flexibility to sell, hold, or transfer their shares, treating them like any other shares they own. This gives employees more control over their equity compensation.
One significant tax consideration for RSUs is that they are taxed as ordinary income at the time of vesting. This can influence the timing of any sale or other transactions with the shares.
Employee stock purchase plans (ESPPs)
Employee stock purchase plans (ESPPs) allow employees to purchase company stock at a discounted price, often through payroll deductions over a certain period. This can be a great way for employees to acquire company stock and benefit from its potential growth.
ESPP participants can also benefit from lookback provisions, which further reduce the purchase price of shares and increase profit potential. However, selling ESPP shares triggers tax events, which vary depending on whether the sale is a qualifying or disqualifying disposition.
The tax treatment of ESPP stock purchases is as follows:
- The discount received on ESPP stock purchases is taxable as ordinary income when the stock is sold.
- If the stock is held for more than one year, any gains may be taxed as long-term capital gains.
- For qualifying dispositions, the discount is reported as compensation income.
- Any additional profit is treated as long-term capital gain.
Evaluating and managing equity comp
Understanding vesting schedules, company valuation, and tax implications is critical when evaluating and managing equity compensation.
Vesting schedules and cliffs
Vesting is a process by which employees earn the right to their equity compensation over a period of time. It incentivizes employees to stay with their company longer.
A standard vesting schedule might distribute 1/4 of the shares after one year (known as the cliff), with the remaining shares vesting periodically until the end of a four-year period.
Restricted stock and RSUs ensure employees only gain full ownership, such as voting rights, upon meeting vesting schedules, thus aligning their efforts to the company’s long-term goals.
Reviewing the vesting schedule before accepting an equity offer is crucial, especially if you hold a temporary position, because a long vesting period may reduce your equity value if it’s not fully vested.
The value of equity compensation is influenced by the company’s valuation, often determined by expert annual valuations, book value, or multiples of revenues or net income. To determine the percentage ownership provided through equity compensation, divide the number of equity shares offered by the total fully diluted shares available.
What is dilution?
Dilution occurs when additional shares are issued, reducing the value of existing shareholders’ equity. This is an essential consideration for evaluating equity offers, as it can significantly impact the value of equity compensation.
Assessing a company’s future value is essential for valuing equity compensation. This hinges on understanding growth potential and possible liquidity events like IPOs or acquisitions.
The tax implications of equity compensation vary depending on the type of equity and the timing of transactions. Understanding these implications is crucial for effective management of equity compensation.
Different types of equity compensation come with distinct tax implications, with financial impacts including ordinary income tax, capital gains tax, and potential exposure to Alternative Minimum Tax (AMT).
Holding incentive stock options (ISOs) and ESPP shares for the required period before selling can qualify them for long-term capital gains tax rates, resulting in significant tax savings.
Exercising an 83(b) election can allow employees with Restricted Stock Awards (RSAs) to pay taxes on the equity when granted (upfront) rather than when it vests, which may result in tax savings if the company’s stock value increases by accelerating the start of the capital gains holding period.
Negotiating and maximizing equity compensation
Negotiation is a vital step to maximize the benefits of equity compensation packages. Understanding the equity offer, including the type of equity, vesting terms, and realization requirements, can provide significant leverage in the negotiation process.
While negotiating, it’s important to consider not only the quantity of equity but also additional features, such as the potential for an accelerated vesting schedule, a reduced option exercise price, or retaining equity after leaving the company.
Evaluating job offers with equity compensation
When considering a job offer that includes equity compensation, it’s important to understand the percentage ownership, how the company’s valuation affects the equity, and how it might grow over time.
Assessing the company’s financial health, growth potential, and stage of development is crucial in determining the value and risk of the equity compensation being offered. It’s also important to evaluate your financial requirements and risk tolerance, considering the potential instability of equity versus the stability of a guaranteed salary.
How to negotiate an equity package
Effective negotiation strategies for equity compensation packages require a complete understanding of the equity offer. This includes understanding the type of equity, the vesting schedule, and the realization requirements.
Understanding whether a company is in a strong position and urgently needs talent can provide significant leverage in equity compensation negotiations. This can help you negotiate not only the equity amount but also additional features, such as the potential for an accelerated vesting schedule, a reduced option exercise price, or retaining equity after leaving the company.
Various exercise strategies, such as cash exercises, sell-to-cover, or stock swaps, can help maximize the value of your equity compensation. These strategies can assist you in navigating the complex landscape of equity compensation and ensure that you get the most out of your equity package.
Maximizing the value of equity compensation
Maximizing the value of equity compensation involves more than just negotiation. It also concerns making informed decisions about when and how to exercise your equity.
A cash exercise for options allows employees to pay the strike price upfront, potentially enabling them to retain a larger portion of equity and improve their cash flow. This can be a great option for those who can afford the upfront cost and believe in the company’s long-term success.
A sell-to-cover exercise involves selling a portion of the shares at the time of exercise to cover the exercise costs and taxes. This can be a good option for those who cannot afford the upfront cost of a cash exercise.
Stock swaps offer an alternative to exercising options. They use the value of already-owned shares rather than upfront cash to cover the cost of the new option.
Legal and regulatory considerations
Certain legal and regulatory considerations must be adhered to when navigating the realm of equity compensation. Securities laws ensure that company stock issuance and trading to employees are conducted legally. Both the issuing company and the employee recipients of equity compensation must understand and adhere to these laws to avoid potential legal complications.
Rule 701 exempts private companies from federal securities registration when issuing securities for compensation, provided certain conditions are met. Additionally, private sales of securities without registration are permitted under Section 4(2) and Regulation D, subject to certain conditions.
These laws and regulations play an instrumental role in ensuring the lawful administration of equity compensation plans while protecting the interests of all parties involved. Failure to comply with these laws can lead to penalties and complex legal issues.
Securities laws and regulations
Securities laws and regulations govern how and when a company can legally issue stock to employees, ensuring that these transactions are not treated as a sale to avoid registration requirements.
These regulations aim to:
- Protect both the issuing company and the employee recipients of equity compensation
- Ensure the lawful administration of equity compensation plans
- Protect the interests of all parties involved
Equity compensation is subject to various compliance requirements, including legal and tax considerations. Companies must accurately value equity compensation and seek expert legal counsel to navigate its legal complexities.
Equity compensation may be subject to registration under state laws, SEC regulations, and federal provisions to ensure compliance and prevent legal and tax implications. Private companies often implement buy-back provisions or transfer restrictions to maintain control and prevent the transfer of equity to third parties not affiliated with the company.
Startup equity compensation benchmarks
Equity compensation levels for key positions in startups typically follow certain benchmarks. Here’s an example of how a startup’s equity comp plan may be set up.
- CEO: 5–10%
- COO: 2–5%
- VPs: 1–2%
- Independent board members: 1%
- Directors: 0.4–1.25%
- Lead engineers: 0.5–1%
- Senior engineers: 0.33–0.66%
- Managers or junior engineers: 0.2–0.33%
These benchmarks provide a ballpark figure to negotiate equity compensation. However, the actual value can significantly increase if the company’s stock appreciates over time.
Equity compensation is a powerful tool used by companies to attract, retain, and incentivize employees. While it can seem complex, understanding the different types of equity compensation, their tax implications, and how to negotiate and manage them can help employees maximize their benefits.
Frequently Asked Questions
What are some examples of equity compensation?
Equity compensation includes stock options, restricted stock, stock appreciation rights (SARs), and ESPPs and provides employees with a stake in the company’s ownership. It is a form of non-cash pay offered by companies to their employees.
What is the most commonly used form of equity compensation?
The most commonly used form of equity compensation is stock options, which come in two varieties: Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs). Stock options give the holder the right to buy or sell shares of a particular stock at a predetermined price within a specific time frame.
How does equity compensation work in a startup?
Equity compensation in a startup involves offering employees a share in the ownership of the company as part of their overall compensation package, typically through stock options, restricted stock units, or other forms of equity-based awards, to attract top talent and compensate for lower initial salaries.
What does it mean to have equity as an employee?
Having equity as an employee means having a stake in your company’s potential success.
What is an equity grant?
An equity grant is a non-cash compensation that grants someone a percentage of ownership in a company, often in the form of stock options, restricted stocks, or stock appreciation rights.