Working for a paycheck? That’s so 20th century. The trend toward equity compensation has only accelerated over the past decade as companies look for new and creative ways to attract and retain top talent. What’s more: The movement is no longer limited to c-suite executives or technology startups
Being more popular, though, doesn’t mean these equity compensation packages are easily understood. This article looks at the most popular types of equity-based compensation, how to evaluate these incentives as part of your pay package, and how to avoid making some common mistakes.
Generally speaking, we tend to look at equity compensation as a hierarchy, with restricted stock units (RSUs) as the most valuable offering, followed by incentive stock options (ISOs), and then non-qualified stock options (NSOs). We also consider employee stock purchase plans. Let’s look at why that is.
What are RSUs?
RSUs are shares of stock issued by a company to employees under an umbrella of restrictions or conditions, including when your shares vest (i.e., when you receive them). They are often tied to how long you’ve been with the company or your performance.
When your shares vest, you receive them at fair market value. In other words, if your company’s share price is $20 when 100 shares vest as part of your compensation, you receive those 100 shares, and it’s considered $2,000 (20 x 100) in income. You are taxed on this income whether you sell the shares or not, so sometimes companies withhold a portion of your shares to cover that taxable income.
What are ESOs?
Both ISOs and NSOs fall into the broader bucket of equity stock options (ESOs). If you’re familiar with exchange-traded options, the concept here is similar. If not, here’s a quick recap: The company gives you the right to purchase shares of company stock at a set price within a set timeframe. The exact terms of when you’re allowed to make the purchase and the price of the stock are usually specified in your employment contract, and there are rules about how the exercise price (or strike/purchase price) of the option relates to fair market value.
The differences between ISOs and NSOs are highly technical, but the most notable is tied to tax treatment. ISOs can be more favorable on the tax front—but that’s something you’d want to discuss with your tax advisor when reviewing an employment contract.
Often, these options don’t vest until you’ve been with the company for a certain amount of time, and the rules about how (and whether) you can exercise options if you leave the company vary.
At the end of the day, however, the biggest difference between any type of ESO and RSU is the need to purchase the options, versus being granted shares outright.
Stock purchase plans
Finally, you may be given the opportunity to purchase shares of your company stock at a discount. Like options, you’re required to spend the money purchasing the shares.
Whether these plans make sense for you often depends on your specific circumstances. You may not want additional exposure to your company’s stock if you already have significant holdings, for example. However, if your company is offering you a deal to purchase shares at a 15% discount (or more!) to market prices, you could do so and sell immediately; the difference in price would become taxable income just like the rest of your compensation.
Consider the terms
The terms of equity compensation tend to be tied to employment status or other variables. Whether the offer comes from a public or private company can also have a significant impact on how you evaluate these offers. It’s unlikely you’ll be able to negotiate details around the price of your equity compensation, so you may have more luck negotiating for a different structure or evaluating the tax implications of any compensation package.
While established executives tend to consult tax professionals as a habit when equity compensation is involved, we sometimes see younger employees miss opportunities or end up with a surprise tax bill if they don’t understand the terms of their compensation (particularly vesting schedules, taxable value, alternative minimum tax, and more).
These are all questions we can help you answer. If you don’t have a qualified tax professional, we can introduce you to our network of tax advisors who have specific backgrounds in equity compensation. (These are purely recommendations; we have no financial relationships with any of the firms we refer clients to, and we suggest you interview several advisors to find one you’re comfortable with.)
Ultimately, equity compensation can be a big opportunity to build wealth outside of traditional salary packages. And with a combination of tax AND financial planning, we may be able to spot opportunities and help you mitigate risk as you navigate different pay packages throughout your career.
