Given the rise in popularity of equity as a form of employee compensation – and thus, as a portion of American’s wealth – we decided to compile and publish an overview of the basics of popular forms of equity compensation.
It’s not uncommon for company stock to dominate an individual portfolio. A study focused on 401ks found that a non-trivial portion (6%) of participants actually had the vast majority (over 80%) of their 401k’s invested in company stock. This trend is pronounced in Silicon Valley, where capital-hungry companies defer cash compensation to their hard-working employees by promising a share of future growth via equity.
“Equity compensation is particularly relevant in Silicon Valley. Whereas about a third of employees of companies that have stock have stock options, the number is over fifty per cent for technology companies,” says Paul Bergholm, Personal Capital’s CFO.
Equity is a great form of compensation. It aligns incentives between employees and employers and enables employees to build long-term wealth. However, while equity compensation may provide you more upside, beware: it can create complications relative to cash compensation. For many readers, understanding how equity actually works and what steps you can take is critical to intelligently managing your wealth.
This blog post will help you understand your equity compensation so you can make better decisions to manage your wealth. This post is the first in a series on equity compensation and covers: 1) the major different types of equity compensation, 2) key dates to keep in mind, 3) tax considerations and 4) key frameworks to keep in mind when managing exposure to your employer in the context of a broader portfolio strategy. We’ll devote future blog posts to topics such as valuing your options, negotiating your option package and exercising your options.
1) Overview of Main Types of Equity Compensation
This overview is intended to give you a sense of the nuts and bolts of equity compensation and the major terms to look out for. If you’re familiar with them, skip to section 2, which covers key dates.
All of the terms vary according to your equity plan, which you should have been provided by your employer (If you haven’t, you should ask for it!). And keep in mind, your financial planner and tax accountant can help you figure out how they apply to your personal situation.
Stock options are probably the most well-known form of equity compensation. Because they have attributes that make them attractive to employees and they merit favorable accounting treatment for companies – at least, they did before 2004 – they’ve traditionally been the most popular. In Silicon Valley, the term option is often used interchangeably with employee equity (but read on, there are important differences!).
So just what are stock options? A stock option is the right to buy a specific number of shares company stock at a pre-set price, known as the “exercise” or “strike price,” for a fixed period of time. As the holder of a stock option, count yourself lucky for the favorable tax treatment and upside potential relative to other forms of equity compensation, but make sure you understand the upside comes with more risk, and that you’ve got some work to do. Here’s a quick review of each of these statements:
- Favorable Tax Treatment. Stock options may be treated by the IRS as equity interests – not income (read on for the difference between “ISOs” and “NSOs”).
- Upside Potential. Stock options often have more upside potential than restricted stock because you typically get more options per grant. This is enhanced by options’ inherent investment leverage – because the effective value of your options is the market price less the exercise price, small changes in market price are amplified in your effective value (in other words, the same absolute price movement is higher on a percentage basis for your “equity”).
- More Risk. The notion of investment leverage means that just as gains are magnified, so are losses magnified. Options have no value at all unless the market value is greater than the exercise price. Further, if you exercise your options and the price decreases, the money you used to purchase the shares and the taxes associated with the exercise have been “spent”.
- More Work. The bulk of the complexity of option-decision-making derives from the fact that as an owner of option, you have to decide both when to buy (exercise) and when to sell.
There are two major types of options that it’s important to be aware of: incentive stock options (“ISOs”) and non-qualified stock options (“NSOs”). ISOs can only be granted to employees, while NSOs can be granted to anyone. ISOs have more favorable tax treatment. While NSOs are subject to ordinary income tax upon exercise on the difference between the fair market value at time of exercise and exercise price and are subject to payroll/income tax withholding, ISO’s are not taxed until they are sold (alternative minimum tax (“AMT”) may be applicable at time of exercise but any taxes paid can be treated as a refundable AMT credit in future years). Upon sale, all options are taxed on the difference between fair market value at sale and the fair market value of purchase/exercise.
In the wake of the 2004 accounting rule change (FAS 123R) – which eliminated the loophole whereby companies could avoid recognizing compensation expense by issuing options – restricted stock has emerged as a preferred form of equity compensation. There are two basic types: restricted stock awards (“RSAs”) and restricted stock units (“RSUs”).
RSAs are grants of company stock that are issued to employees in the form of rights to shares of stock that are restricted (i.e. cannot be transferred) until the shares vest (see next section for more detail on what vesting means). Typically, companies issue shares that are held in escrow and are released upon vesting.
RSUs are the second type of restricted stock grant. Like RSA’s, RSUs are stock awards that are subject to vesting requirements and transferability restrictions. The key difference is that RSU’s are issued in the form of units – not stock – which correspond in number and value to a specified number of shares of employer stock. Upon vesting, you’ll get your equivalent shares. The net of this difference is that RSU-holders are not deemed to be holders of the shares until vesting and do not have voting rights. This makes it a particularly popular mechanism in Silicon Valley for pre-IPO companies: RSU holders are not technically shareholders and increasing ownership does not trigger SEC filing rules.
From those of you who hold restricted stock, you should appreciate that they’re less risky, easier to manage and have similar rights as regular stock. However, they’ve got less favorable tax treatment than options. Here’s a quick review of each of these statements:
- Less Risky. Restricted stock is less risky than options because the grant price is generally zero and any value above zero is compensation to you. In other words, unlike options, they have downside protection. However, they’re still risky in that their value is dependent on the value of the security!
- Easier to Manage. Restricted stock is easier to manage than options in that it requires fewer decisions; upon vesting, you get access to the shares you’ve been awarded. Unlike stock options, all restricted stock is taxed as ordinary income on the fair market value on vesting date. Capital gains tax is also levied upon sale of the stock.
- Less Favorable Tax Treatment. Restricted stock is always taxed at ordinary income levels on the net amount between the fair value on date of vesting and the exercise price (normally, zero). Your employer will withhold the appropriate taxes for you. As a holder of vested stock, you are also taxed at sale at the appropriate capital gains rate based, with the clock starting from vest date.
It’s worth pausing to note that you may have options with respect to how your employer withholds taxes on your restricted stock-income. There are three standard withholding methods which need to be decided within 30 days of settlement: 1) net shares, 2) pay cash or 3) sell to cover. In net shares, you receive only the portion of shares after covering the cost of your income taxes. For instance, if you were entitled to 100,000 shares and pay a 40% marginal tax rate, you’d get 60,000 shares. Because market price doesn’t impact your tax, this is the least risky strategy. By choosing to pay cash, you receive all your shares and cover or income tax burden with other cash savings. If you believe your company’s share price is going up, this might be an attractive strategy. However, it’s riskier as you end up equity and you have depleted your cash reserves to cover the income tax burden. Finally, by selling to cover, you can sell shares on your own and use a portion to cover your tax withholding obligation. This is similar to paying cash in that you assume the risk of the share price (for the period of time before you sell), but it may be more feasible in that you don’t need to have the cash to pay. Make sure to talk to your employer to see what options are available to you.
2) Key Dates
The Grant Date. When you’re offered equity by your company, you need to decide: do you accept the grant? This is typically a no-brainer. But note, if the grant is restricted stock with par value, accepting the grant means you’ll eventually be required to pay for those options when they vest. While there’s typically no option to transfer shares, you may be able to fill out a Beneficiary Distribution Form.
For restricted stock, there’s also the opportunity to make what’s known as an 83(b) election with the IRS. That election notifies the IRS to lock down the fair market value at the time of grant – and so you owe any income tax on the grant date on the difference between the fair market value of the grant and the amount paid for the grant (if any). The 83(b) election starts the clock earlier for capital gains purposes when you eventually sell your stock. And if the stock price increases between grant date and vest date, it means lower income taxes. However, it also introduces a new risk; if you leave the company before your shares vest, you can’t recover those taxes.
Vesting Schedule. As we’ve noted in the equity compensation comparison table, employers often include time or performance-based restrictions as part of employee compensation packages. These restrictions are meant to encourage employee retention and align incentives between the employee and the firm. When these criteria are met, the stock will vest.
Time restrictions, sometimes called service restrictions, relate to the length of time an employee is employed with the company. A typical service restriction might read as follows: options vest monthly over four years with a one-year “cliff.” That means for the first year, no vesting occurs on your options. On your first year anniversary, 25% of your grant vests and the remaining portion of the grant will vest monthly for the remaining three years.
Performance restrictions limit access to equity based on the achievement of pre-set goals, which can encompass both company and individual performance. Revenue growth, margin improvement and achievement of development milestones are all examples of performance goals. Performance restrictions can also include market events – the Facebook and Twitter RSU programs, for instance, include the company IPO as a performance restriction. In the event of an IPO, the performance date is set for a specified amount of time after the IPO. The extra buffer is called a “lock-up,” and prevents employees from flooding the market with stock sales.
Before your shares vest, you generally cannot sell or exercise stock – except in the event that your stock option plan allows early exercise. (NB: In the event that you are able to exercise your options before vesting, you can make the 83(b) election. Similar to with restricted stock, this starts the clock early for capital gains by notifying the IRS to lock down the fair market value at time of exercise rather than vesting. You’ll have 30 days from early exercise to file this).
Upon vesting, a whole new set of decisions need to be made. If you have options, do you exercise? For RSU holders, do you defer settlement? For all equity compensation, when do you start selling? If your employer is withholding tax, which withholding method serves you best? There are smart tactics to go about making all of these decisions – which we’ll write about more in our post about exercising options.
3) Tax Considerations
The following table summarizes the tax rules for each type of equity award.
Once you’ve figured out how to navigate your equity compensation, how do you use that knowledge to intelligently manage the wealth you have tied up in your company? Here’s a three-step framework:
A). Take Stock of Overall Financial Picture
The first step is figuring out what your current financial picture is, and how much of your wealth will be tied up in your company stock. There are lots of calculators out there that help you to forecast what your options or RSU’s are worth now. The Personal Capital stock option tracker can help you visualize your equity ownership as a piece of your overall net worth – you can read more detail about it here.
B). Identify Your Goals
Second, outline your goals. Do you want to buy a house in the next few years? Do you have children, and if so, have you started planning for your education? What have you done so far to save for your own retirement? Have you considered how you might need different investing strategies to meet these different goals?
C). Manage Your Exposure in the Context of Your Financial Picture
Finally, armed with an understanding of your current financial standing and where you want to be, you can design a game plan for managing your company stock as part of your wealth management strategy.
The first question is: how much of your company stock is it appropriate for you to own? There’s no exact answer – like health, all our financial pictures are different. And further, you can’t predict how that stock will perform. But here are few things to keep in mind. First, consider that the volatility of a single stock is high – according to Morningstar, the average difference between the yearly high and low of stock prices of a typical NYSE stock is 40%. Second, consider the fact that IPO’s are particularly risky; on average, IPO stocks on average underperform the market by 5.2% per year in the first five trading years, according to a study by IPO expert Jay Ritter.
Rather than let your employer stock dominate your portfolio, at Personal Capital, we believe that part of intelligently managing your wealth is figuring out how to sell down some of your shares to build a diversified portfolio that’s appropriate for your risk capacity. Read our blog post about why building a diversified portfolio across the major global asset classes that is on the efficient frontier helps you to maximize your risk-adjusted return.
As a final note, that’s not to say you shouldn’t take advantage of programs like the Employee Stock Purchase Programs (“ESPPs”) that entitle employees to purchase stock at a discount to market price. It’s important to stay on top of your employer’s ESPP to make sure you understand that opportunity – even if it means buying shares at the discount offered and selling immediately.
As equity compensation becomes a bigger portion of our compensation and wealth, it’s ever more important to understand the nuts and bolts of the various types of stock awards. Given that there are lots of rules and terms to think about, you can use this post as a reference manual. It can also help to talk to an expert to get more personalized guidance – whether it’s your CFO or someone in your HR department or a financial advisor.
In the next post in our series on options, we’ll show what someone’s equity compensation grant actually looks like. From there, we’ll publish some further posts that illustrate tactical considerations around negotiating, managing and exercising those options.
Image credit: Wikipedia
 Study of 24 million 401k plan participants, representing $1.4 trillion in assets by the Employee Benefit Research Institute and the Investment Company Institute (“401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2011” as of December 2012).