Besides the free backpack, soundbar, and t-shirt, how’s a company to incentivize its employees? Isn’t a paycheck enough!? To retain high-performing employees, equity has become an important component in many companies, especially start-ups.
Within the realm of company equity there are six different equity options or compensation types you may come across throughout your career.
- Small startups will tend to use RSAs (restricted stock awards).
- Growing startups will tend to use stock options (ISOs “incentive/qualifying/statutory” stock options or NSOs “non-qualifying/non-statutory” stock options).
- Larger companies will use RSUs (restricted stock units).
Additionally, you may have access to equity plans, like
- ESOPs (at closely held private companies)
- ESPPs (at larger public companies).
In this article we will dive into some of the key differences so you have a better understanding of what these types of equity benefits may do for your financial future. Before we do, let’s knock out some terminology:
- Vesting: a period of restricted entitlement to equity. If you leave a company before you have vested, you lose your ownership.
- Fair-market-value: the most up to date value of the equity. If a company is publicly traded this would be its current stock price. If a company is still private this is likely the most recent 409(A) valuation.
- Grant: the day when the equity is promised to you although it does not always indicate ownership.
- Escrow: a holding account typically owned by a bank or company.
- Strike price: the price of the shares if you decide to exercise
- Capital gains tax: Tax on growth of equity investments. If held longer than one year it is considered “long-term”. If held less than one year it’s considered “short-term”.
RSA vs RSU
RSAs and RSUs involve direct equity ownership, as opposed to equity options which can be exercised. They are restricted in the sense that there is usually a vesting schedule before the equity becomes wholly yours (so you don’t work at your company for 1 day, collect the equity, and leave). RSAs tend to be given to early-stage start-up employees, and RSUs are given in more late-stage companies.
With an RSA, the employee has the right (if they want) to purchase equity in the company for fair-market-value, a discount, or nothing, depending on the documented terms. The employee owns the stock immediately, but it is held in escrow until it fully vests (and if you leave the company early they will buy the unvested equity back from you).
RSUs are promises made by your company, to give you shares in the future, typically on a vesting schedule (there can sometimes be other conditions, like performance). You do not own the shares immediately at the grant, you must wait for vesting. If you leave the company before the RSUs vest, they are forfeit.
How are they taxed?
For an RSA, when you purchase the equity, there are no taxes. But then as they vest, you’ll have to pay ordinary income tax on any gain from purchase price to their current fair-market-value (at vesting). Then, when you sell the equity, you’ll pay capital gains tax on any additional gains (the gain from fair-market-value at vesting to the sale price). Income tax is typically higher than capital gains rates, so it can be challenging to pay income taxes on these shares as they vest because you may not have easily tradable shares yet. This means you have to find the cash to pay the taxes out of your own savings.
One way around this, albeit this involves a higher amount of risk because you may not know if the company will ultimately go public, is to do an 83(b) election within the first 30 days of getting your RSA grant. This lets you pay for your income tax immediately (instead of waiting for vesting). This can be beneficial because there might be zero income tax (if you purchased the shares for current fair-market-value), or it might be really small (if you purchased at a discount or received for free). Remember, you are paying tax on the difference between what the purchase price is and what it’s worth on the day you buy it. Then, when you sell your shares, you’ll pay capital gains taxes on all the gains above what you paid for them at the grant. This is significantly better than the previous scenario, so if possible, use an 83(b) election within your first 30 days of getting an RSA grant if you are willing to take on that additional risk. (Example)
For RSUs, when they vest you pay ordinary income tax on their full value (essentially like a cash bonus that is taxed and then immediately invested in your company’s stock). There’s no way around this (no 83(b) election). When you sell you’ll pay capital gains taxes on any additional increase in share price. RSUs can quickly under diversify your overall assets because you may have a large percentage of your liquid net worth in one company stock. We recommend trying to keep this to 10% or less therefore it might make sense to sell your RSUs immediately after they vest to minimize your capital gains tax.
While it’s most common to receive RSUs when your company is already publicly traded there is also a possibility that you are granted these pre-initial public offering (IPO). If this happens to you, there may be what’s called a “double-trigger” which requires that not only are the RSUs vested but there needs to be a liquidity event. The liquidity event would be either (1) the company goes public (2) is acquired or merged (3) has the ability to be sold in a private equity market. The rationale for this is if the shares are taxed as income when received but you can’t sell them to pay the tax that could create challenges. Therefore most companies will not have you taxed on the RSUs until both events happen: vesting and a liquidity event.
ISO vs NSO
We’ll cover the highlights of equity options as it relates to ISOs and NSOs, but our full article is here. As is the case with RSAs, ISOs and NSOs grant you the option to buy company stock and participate in future growth. If your company grants you options to buy 10,000 shares of your company, there will typically be a vesting schedule for the options. A standard vesting schedule is 4 years with a 1-year cliff. This would mean that after you work for your company for a year, you vest 2,500 options (25%), then every month you vest 208 options (1/48th) until all 10,000 are vested after 4 years.
Your options come with a strike price, which is what you have to pay for the equity. Let’s say your strike price is $0.10. You have the option of purchasing 10,000 shares of equity in your company for 10 cents each (costing you $1,000). You don’t have to, but you can if you want to (after they vest).
To figure out what your equity is worth, check your company’s most recent 409A appraisal (if private) or current stock price (if public and trading already). It’s important to note that as planners, we don’t include the value of your equity into your future finances unless it is already public. If you can’t sell and obtain cash from your investment at present day we don’t want to count on that money.
Say you exercise your options in 4 years when the equity is worth $10/share and your company goes public in 5 years for $30/share. When you exercise your 10,000 options, you basically write a check to your company for $1,000 (= 10,000 shares * $0.10 strike). Then when the company goes public you can sell them on the exchange for $30 each, netting you $299,000. Not bad, right?
How are they taxed?
So, what is the difference between ISOs and NSOs? It comes down to our favorite topic of discussion, taxes. ISOs qualify for favorable tax treatment while NSOs are non-qualifying (for favorable tax treatment). In our previous example, you are granted 10,000 options in year 0, you exercise in year 4 for $0.10 when the equity is worth $10/share, and you sell in year 5 for $30/share.
Let’s talk about the less favorable tax case first, NSOs. When you exercise in year 4, you have to pay ordinary income tax on the spread from strike to fair-market-value (from $0.10 to $10, around ~30% income tax depending on your bracket), and you have to have it withheld immediately when you exercise (you don’t get to wait until the following April to pay it). Though you haven’t actually sold the equity yet (you’ve just bought it!), you still have to pay income tax on the unrealized gains. Then when you do sell the equity in year 5, you have capital gains (or losses) that you report (the difference between what you sell it for in year 5 and what the fair market value was when you exercised in year 4).
In this example, you have $20 of long-term capital gains ($30-$10 = $20) that you’ll pay ~15-20% capital gains taxes on (as of 2020).
ISOs have better tax treatment. When you exercise, you may have to pay AMT on the spread from strike to fair-market-value (could be up to 28%). A digital equity management software like Carta provides an exercise simulator to estimate the AMT you owe (you could owe nothing, we recommend consulting a tax advisor). Then, later, when you sell the equity, you’ll pay capital gains on the whole amount, from strike to selling price. If you previously paid AMT, you will be paying double taxes on part (from strike to fair-market-value at exercise), but you can get the AMT part back through credits (though it may take time). Once you get the AMT credits back, you will effectively have paid capital gains taxes on the whole amount, from strike to selling price. This is typically much lower than ordinary income tax, which is paid for NSOs (on the part from strike to fair-market-value on exercise date).
A few other fun tidbits, you can only have $100,000 of ISOs vest per year (by strike price). Anything over that is automatically NSOs. 83(b) elections also work here (to avoid AMT/Ordinary income tax that typically happens at exercise). When you leave your company, you’ll have to decide whether or not you want to exercise your ISOs within 90 days, NSOs can give you more time.
ESOP vs ESPP
ESOPs (Employee Stock Ownership Plans) are pretty interesting. They try to do multiple things simultaneously:
- Provide a way for owners to sell their equity/create an internal market for the equity of closely held companies,
- Give employees equity ownership while they work for the company,
- Increase retirement savings of employees.
From the employee’s perspective, your employer contributes company stock to a pre-tax retirement account (similar to a pre-tax 401k) for you (subject to a vesting schedule). When you leave the company, your employer buys the equity back from you, leaving cash in this pre-tax retirement account, which you can then roll to a pre-tax IRA. Though you don’t keep the equity after you leave, it is a nice ‘bonus in your retirement account’ that you don’t have to pay for.
ESPPs (Employee Stock Purchase Plans) involve purchasing equity from your employer at a discount (in larger publicly traded companies). You’ll typically contribute to an ESPP from payroll deductions (after-tax money) at a predetermined interval (like 6 months). Those deductions are used to buy your company’s stock at a discount (up to 15% off). As with RSUs, your diversification can suffer with regular contributions to an ESPP so consider selling the shares as soon as you purchase them. If you hold the stock longer, when you sell you will still pay ordinary income tax on the discount and capital gains on any increase in share price above that.
To conclude, all of these equity ownership plans can be beneficial, and in general it is a good idea to participate.
If you’re a really early employee at a start-up, you might be getting RSAs or options. Consider the cost/tax-implications of using an 83(b) election to pay all income taxes up-front (which may be low or zero).
If you’re at a tightly held private company with an ESOP, it’s basically free money they’re contributing to a pre-tax retirement account for you. Don’t pull the money out when you quit (and pay taxes and penalty), but roll into a pretax Traditional IRA.
If your company gives you RSUs or has an ESPP, consider the weighting to your employer equity and maybe sell the shares immediately at vest/ purchase, paying the ordinary income tax on their ‘gift’ to you (the RSUs or the discount), and reinvesting in a more broadly diversified way (in a taxable investment account).
As always, it’s important to talk to a tax professional (CPA) when evaluating what is right for your situation.