Equity compensation is a powerful tool for motivating and rewarding your team, but it's essential that you get the details right. Here are some best practices to help you use equity effectively in your company.
Employee equity compensation is one of the most popular employee benefits companies offer, but it’s also very complex. If you’re an HR manager trying to understand this topic or an employee trying to educate yourself about this topic, you’ve come to the right place.
In this blog post, we’ll answer your most commonly asked questions about equity compensation in simple, easy-to-understand terms.
Editor’s note: Want to know more about equity and stock options? Download our free eBook to help you better understand employee equity compensation.
What is equity compensation?
Let’s start with the basics.
Equity compensation is non-cash pay that gives employees an ownership stake in the company. It can be in various forms, including options, restricted stock, and performance shares.
How does equity-based compensation work?
Equity compensation is most commonly associated with startups, but private and public companies offer it.
It’s a popular option for organizations who want to attract and retain talent, but either doesn’t have enough cash flow or want to invest their profits into its growth. By giving employees equity as part of their salary, employers can supplement the base salaries and give people the chance to share in the company’s profits through appreciation.
What are the types of equity compensation?
There are 3 common categories of equity compensation:
1. Stock options
This is an offer that gives employees the right to purchase (“exercise”) shares of a company’s stocks at a predetermined price (“strike price”), subject to specific time limits and conditions.
There are two types of stock options:
Incentive Stock Options (ISOs)
ISOs are a type of stock option that gives employees the right, within a designated timeframe, to buy a set number of their company’s shares at a predetermined price. ISOs can only be offered to employees.
Non-qualified Stock Options (NSOs)
NSOs are a type of stock option that gives employees the right, within a designated timeframe, to buy a set number of their company’s shares at a predetermined price. NSOs can be offered to both employees and non-employees.
2. Employee Stock Purchase Plans
This is a company-run program that offers employees the ability to purchase company stock at a discounted price. To participate, employees contribute to the plan through payroll deductions and, on the purchase date, the company uses the employee's accumulated funds to purchase stock in the company at a discount.
3. Restricted shares
Restricted Stock Units (RSUs) offer employees (typically at larger, public companies) a set number of shares of stock at a future date, upon the completion of a vesting schedule. Unlike options, employees don’t have to buy RSUs—they’re just given.
Restricted Stock Awards (RSAs) give early employees (typically at startups) a set number of shares of stock, at no cost on the grant date or at a discounted price.
What is vesting?
Vesting refers to the period of time an employee must wait to fully exercise their rights to certain assets. Vesting periods are typically applied to stock options, RSUs, retirement funds, and certain benefits.
How is equity compensation taxed?
Every type of equity compensation has slightly different tax implications. Here’s a high-level overview of tax considerations for stock options and restricted shares.
- No taxes at grant or vesting
- No income taxes payable at exercise but may potentially owe AMT at the end of the year when the employee does their taxes
- With qualifying disposition, receive capital gains treatment on everything above the strike price
- No taxes at grant or vesting
- Ordinary income tax due on the bargain element immediately at exercise
- When selling, receive capital gains treatment on everything above the bargain element (the FMV at exercise)
- No taxes at grant
- Can’t file for 83(b) election
- Taxed as ordinary income at vesting and is subject to capital gains taxes after selling
- No taxes at grant or purchase of RSAs
- Can choose to file for 83(b) election
- Ordinary income taxes at vesting on the difference from purchase to vesting 409a FMV, unless the employee filed for 83(b) election at purchase
ESPPs are a bit different. The specific tax impact of disposing of ESPP stock will vary depending on four factors:
- The length of time the stock is held
- The price the stock is actually purchased at, factoring in the discount
- The price of the stock on the offering date
- The price of the stock on the purchase date
For a more in-depth guide on taxes, check out our guide to understanding equity compensation.
How do you value equity compensation?
There are a few factors employees have to consider when it comes to understanding the value of their equity compensation:
To understand the value of their equity, the employee has to know their percentage of ownership. To calculate percentage ownership, take the number of shares offered and divide by the total number of fully diluted shares outstanding.
- The number of shares given should be available in the employee’s original offer letter or the equity manager platform they use.
- The number of fully diluted shares can be found by asking someone on the HR or finance team at the company.
Once the percentage ownership is calculated (i.e. 0.001%), multiply it by the company’s current valuation to find the value of the options. Keep in mind that the strike price, taxes, and other factors may affect the amount.
If your employee is looking for a simpler way to calculate this number, Origin’s Equity Manager has a simulator tool that projects the value of equity holdings based on company growth scenarios that employees can manipulate directly.
Another factor to take into consideration is the vesting period. Most stock options have a four-year vesting schedule and a one-year cliff. In other words, employees own zero options in their first year of service.
After their first year with the company, they’ll receive 25% of the options they were granted and then incrementally more every month until they reach four years. This will also determine the value of their stock options.
Keep in mind that if an employee leaves the company for a new job, gets laid off, or retires, they typically have a window of 90 days to exercise their options. If they’re not exercised in this timeframe, they expire.
Also, it’s important to note that these valuations only matter if the company ultimately has a successful exit—whether that’s through an IPO or acquisition. So the employer shouldn’t assume their stock options will be worth any significant amount during their time with the organization.
What happens to employee stock when a company goes public?
In the simplest terms: after a company IPOs, an employee will be able to sell their stock options. When a private company is about to go public, there are a few things employees should do to prepare for this transition:
- Review the stock plan document. When a company initially sets up its stock option program, they have to create a document called a stock plan. This outlines the guidelines for how options are granted, how they work, and what the option holder needs to know. Pre-IPO is the perfect time for the employee to review this document.
- Understand the lock-up period. After an IPO, there’s typically a lock-up period—a number of days after an IPO during which shares cannot be sold by company insiders, which includes employees. The details of the lock-up period should be communicated by the company.
- Seek out the guidance of financial advisors. This is the best time for employees to hire a financial advisor to help them navigate the IPO. Or, as an employer, you can also offer them a financial wellness platform to help them understand what to do with their stock options.
How do you exercise employee stock options?
For stock options, employees typically have one of four options:
- Exercise and hold: This is when the employee exercises their options and holds the equity in anticipation of an IPO or future liquidity event. Or, if the company is public, the employee may hold the equity for more than one year to receive better tax treatment before selling. If they hold the equity beyond December 31 following exercise, the employee may owe AMT when they file their taxes.
- Exercise and sell: If a company goes public and the employee still hasn’t exercised their options, it may make sense to do a same-day exercise-and-sell of vested options. Unfortunately, these gains will be taxed as ordinary income. However, it’s a riskless scenario and the employee will still have proceeds they can use for other purposes. The employee could also choose to stretch the timing out and opt to exercise-and-sell in the same calendar year. With this option, the gains will still be taxed as ordinary income, but it’ll no longer be riskless as they’ll be exposed to the employer equity price fluctuations until they sell.
- Exercise and partially sell: This is when the employee exercises their options and sells a portion of their shares—usually to use those proceeds to help exercise the rest of the equity. The part of the equity that’s sold will be taxed as ordinary income, but the part that’s not sold will usually receive better tax treatment if held for more than one year.
- Stock swap: The exchange of one equity-based asset for another that typically happens during a merger or acquisition, where ownership of the target company's shares is exchanged for an equal value of shares of the acquiring company.
How do you make the right decisions about equity?
It’s critical for employees to have a trusted financial advisor who can help them understand their equity compensation and guide them toward the right decisions, depending on their financial goals.
However, financial advisors are out of reach for most people. Another way to support employees—especially if your company is planning to IPO soon—is to introduce Origin as a benefit.
Our Equity Manager product contains a suite of tools that allow employees to get a comprehensive overview of your equity, educate themselves, and even simulate the value of their compensation over time. Our platform, paired with personalized guidance from our network of CFP® professionals, will empower your people to make the most informed and confident decisions about equity compensation.
Hopefully, this article answered some of your most common questions about equity compensation. Having this basic knowledge can make a huge difference in educating your employees or understanding the value of your stock options. Want to learn more about the ins and outs of equity compensation? Download our guide.