Given the rise in popularity of equity as a form of employee compensation \u2013 and thus, as a portion of American\u2019s wealth \u2013 we decided to compile and publish an overview of the basics of popular forms of equity compensation.\r\n\r\nIt\u2019s not uncommon for company stock to dominate an individual portfolio.\u00a0 A study focused on 401ks found that a non-trivial portion (6%) of participants actually had the vast majority (over 80%) of their 401k\u2019s invested in company stock.\u00a0 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.\r\n\r\n How Much Employer Stock is in Your Portfolio? Use Personal Capital's Free Allocation Tool to See for Yourself. \r\n\r\n\u201cEquity 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,\u201d says Paul Bergholm, Personal Capital\u2019s CFO.\r\n\r\nEquity is a great form of compensation.\u00a0 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.\u00a0 For many readers, understanding how equity actually works and what steps you can take is critical to intelligently managing your wealth.\r\n\r\nThis blog post will help you understand your equity compensation so you can make better decisions to manage your wealth.\u00a0 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.\u00a0 We\u2019ll devote future blog posts to topics such as valuing your options, negotiating your option package and exercising your options.\r\n\r\n1) Overview of Main Types of Equity Compensation\r\n\r\nThis overview is intended to give you a sense of the nuts and bolts of equity compensation and the major terms to look out for.\u00a0 If you\u2019re familiar with them, skip to section 2, which covers key dates.\r\n\r\nAll of the terms vary according to your equity plan, which you should have been provided by your employer (If you haven\u2019t, you should ask for it!).\u00a0\u00a0 And keep in mind, your financial planner and tax accountant can help you figure out how they apply to your personal situation.\r\n\r\nKey Terms\r\nStock Options\r\n\r\nStock options are probably the most well-known form of equity compensation.\u00a0 Because they have attributes that make them attractive to employees and they merit favorable accounting treatment for companies \u2013 at least, they did before 2004 \u2013 they\u2019ve traditionally been the most popular.\u00a0 In Silicon Valley, the term option is often used interchangeably with employee equity (but read on, there are important differences!).\r\n\r\nSo just what are stock options?\u00a0 A stock option is the right to buy a specific number of shares company stock at a pre-set price, known as the \u201cexercise\u201d or \u201cstrike price,\u201d for a fixed period of time.\u00a0As 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\u2019ve got some work to do.\u00a0 Here\u2019s a quick review of each of these statements:\r\n\r\n \tFavorable Tax Treatment.\u00a0 Stock options may be treated by the IRS as equity interests \u2013 not income (read on for the difference between \u201cISOs\u201d and \u201cNSOs\u201d).\r\n \tUpside Potential. \u00a0Stock options often have more upside potential than restricted stock because you typically get more options per grant.\u00a0 This is enhanced by options\u2019 inherent investment leverage \u2013 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 \u201cequity\u201d).\r\n \tMore Risk. \u00a0The notion of investment leverage means that just as gains are magnified, so are losses magnified.\u00a0 Options have no value at all unless the market value is greater than the exercise price.\u00a0 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 \u201cspent\u201d.\r\n \tMore 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.\r\n\r\nThere are two major types of options that it\u2019s important to be aware of: incentive stock options (\u201cISOs\u201d) and non-qualified stock options (\u201cNSOs\u201d).\u00a0 ISOs can only be granted to employees, while NSOs can be granted to anyone.\u00a0 ISOs have more favorable tax treatment.\u00a0 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\u2019s are not taxed until they are sold (alternative minimum tax (\u201cAMT\u201d) may be applicable at time of exercise but any taxes paid can be treated as a refundable AMT credit in future years).\u00a0 Upon sale, all options are taxed on the difference between fair market value at sale and the fair market value of purchase\/exercise.\r\n\r\nRestricted Stock \r\n\r\nIn the wake of the 2004 accounting rule change (FAS 123R) \u2013 which eliminated the loophole whereby companies could avoid recognizing compensation expense by issuing options \u2013 restricted stock has emerged as a preferred form of equity compensation.\u00a0 There are two basic types: restricted stock awards (\u201cRSAs\u201d) and restricted stock units (\u201cRSUs\u201d).\r\n\r\nRSAs 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).\u00a0 Typically, companies issue shares that are held in escrow and are released upon vesting.\r\n\r\nRSUs are the second type of restricted stock grant.\u00a0 Like RSA\u2019s, RSUs are stock awards that are subject to vesting requirements and transferability restrictions.\u00a0 The key difference is that RSU\u2019s are issued in the form of units \u2013 not stock \u2013 which correspond in number and value to a specified number of shares of employer stock.\u00a0 Upon vesting, you\u2019ll 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.\u00a0 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.\r\n\r\nFrom those of you who hold restricted stock, you should appreciate that they\u2019re less risky, easier to manage and have similar rights as regular stock.\u00a0 However, they\u2019ve got less favorable tax treatment than options. Here\u2019s a quick review of each of these statements:\r\n\r\n \tLess Risky.\u00a0 Restricted stock is less risky than options because the grant price is generally zero and any value above zero is compensation to you.\u00a0\u00a0 In other words, unlike options, they have downside protection.\u00a0 However, they\u2019re still risky in that their value is dependent on the value of the security!\r\n \tEasier 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\u2019ve been awarded.\u00a0 Unlike stock options, all restricted stock is taxed as ordinary income on the fair market value on vesting date.\u00a0 Capital gains tax is also levied upon sale of the stock.\r\n \tLess Favorable Tax Treatment. \u00a0Restricted 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).\u00a0 Your employer will withhold the appropriate taxes for you. \u00a0As 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.\r\n\r\nIt\u2019s 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.\u00a0 In net shares, you receive only the portion of shares after covering the cost of your income taxes.\u00a0 For instance, if you were entitled to 100,000 shares and pay a 40% marginal tax rate, you\u2019d get 60,000 shares.\u00a0 Because market price doesn\u2019t impact your tax, this is the least risky strategy.\u00a0 By choosing to pay cash, you receive all your shares\u00a0 and cover or income tax burden with other cash savings.\u00a0 If you believe your company\u2019s share price is going up, this might be an attractive strategy.\u00a0\u00a0 However, it\u2019s riskier as you end up equity and you have depleted your cash reserves to cover the income tax burden.\u00a0 Finally, by selling to cover, you can sell shares on your own and use a portion to cover your tax withholding obligation.\u00a0 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\u2019t need to have the cash to pay. Make sure to talk to your employer to see what options are available to you.\r\n\r\n2) Key Dates\r\n\r\nThe Grant Date. \u00a0When you\u2019re offered equity by your company, you need to decide: do you accept the grant?\u00a0 This is typically a no-brainer.\u00a0 But note, if the grant is restricted stock with par value, accepting the grant means you\u2019ll eventually be required to pay for those options when they vest.\u00a0 While there\u2019s typically no option to transfer shares, you may be able to fill out a Beneficiary Distribution Form.\r\n\r\nFor restricted stock, there\u2019s also the opportunity to make what\u2019s known as an 83(b) election with the IRS.\u00a0 That election notifies the IRS to lock down the fair market value at the time of grant \u2013 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).\u00a0 The 83(b) election starts the clock earlier for capital gains purposes when you eventually sell your stock.\u00a0 And if the stock price increases between grant date and vest date, it means lower income taxes.\u00a0 \u00a0However, it also introduces a new risk; if you leave the company before your shares vest, you can\u2019t recover those taxes.\r\n\r\nVesting Schedule.\u00a0\u00a0 As we\u2019ve noted in the equity compensation comparison table, employers often include time or performance-based restrictions as part of employee compensation packages.\u00a0 These restrictions are meant to encourage employee retention and align incentives between the employee and the firm.\u00a0 When these criteria are met, the stock will vest.\r\n\r\nTime restrictions, sometimes called service restrictions, relate to the length of time an employee is employed with the company.\u00a0 A typical service restriction might read as follows: options vest monthly over four years with a one-year \u201ccliff.\u201d\u00a0 That means for the first year, no vesting occurs on your options.\u00a0 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.\r\n\r\nPerformance restrictions limit access to equity based on the achievement of pre-set goals, which can encompass both company and individual performance.\u00a0 Revenue growth, margin improvement and achievement of development milestones are all examples of performance goals.\u00a0 Performance restrictions can also include market events \u2013 the Facebook and Twitter RSU programs, for instance, include the company IPO as a performance restriction.\u00a0 In the event of an IPO, the performance date is set for a specified amount of time after the IPO.\u00a0 The extra buffer is called a \u201clock-up,\u201d and prevents employees from flooding the market with stock sales.\r\n\r\nBefore your shares vest, you generally cannot sell or exercise stock \u2013 except in the event that your stock option plan allows early exercise.\u00a0 (NB: In the event that you are able to exercise your options before vesting, you can make the 83(b) election.\u00a0 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.\u00a0 You\u2019ll have 30 days from early exercise to file this).\r\n\r\nUpon vesting, a whole new set of decisions need to be made.\u00a0 If you have options, do you exercise?\u00a0 For RSU holders, do you defer settlement?\u00a0 For all equity compensation, when do you start selling?\u00a0 If your employer is withholding tax, which withholding method serves you best? \u00a0There are smart tactics to go about making all of these decisions \u2013 which we\u2019ll write about more in our post about exercising options.\r\n\r\n3) Tax Considerations\r\n\r\nThe following table summarizes the tax rules for each type of equity award.\r\n\r\n4) Managing Exposure\r\n\r\nOnce you\u2019ve 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?\u00a0 Here\u2019s a three-step framework:\r\n\r\nA). Take Stock of Overall Financial Picture\r\n\r\nThe 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.\u00a0 There are lots of calculators out there that help you to forecast what your options or RSU\u2019s are worth now.\u00a0 The Personal Capital stock option tracker can help you visualize your equity ownership as a piece of your overall net worth \u2013 you can read more detail about it here.\r\n\r\n Sign up for Personal Capital to Use the Free Stock Option Tracker Tool. \r\n\r\nB). Identify Your Goals \r\n\r\nSecond, outline your goals.\u00a0 Do you want to buy a house in the next few years?\u00a0 Do you have children, and if so, have you started planning for your education?\u00a0 What have you done so far to save for your own retirement?\u00a0 Have you considered how you might need different investing strategies to meet these different goals?\r\n\r\nC). Manage Your Exposure in the Context of Your Financial Picture\r\n\r\nFinally, 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.\r\n\r\nThe first question is: how much of your company stock is it appropriate for you to own?\u00a0 There\u2019s no exact answer \u2013 like health, all our financial pictures are different.\u00a0 And further, you can\u2019t predict how that stock will perform.\u00a0 But here are few things to keep in mind.\u00a0 First, consider that the volatility of a single stock is high \u2013 according to Morningstar, the average difference between the yearly high and low of stock prices of a typical NYSE stock is 40%.\u00a0 Second, consider the fact that IPO\u2019s 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.\r\n\r\nRather 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\u2019s appropriate for your risk capacity.\u00a0 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.\r\n\r\nAs a final note, that\u2019s not to say you shouldn\u2019t take advantage of programs like the Employee Stock Purchase Programs (\u201cESPPs\u201d) that entitle employees to purchase stock at a discount to market price.\u00a0 It\u2019s important to stay on top of your employer\u2019s ESPP to make sure you understand that opportunity \u2013 even if it means buying shares at the discount offered and selling immediately.\r\n\r\nIn Summary\r\n\r\nAs equity compensation becomes a bigger portion of our compensation and wealth, it\u2019s ever more important to understand the nuts and bolts of the various types of stock awards.\u00a0 Given that there are lots of rules and terms to think about, you can use this post as a reference manual.\u00a0 It can also help to talk to an expert\u00a0to get more personalized guidance \u2013 whether it's your CFO or someone in your HR department or a financial advisor.\r\n\r\nIn the next post in our series on options, we\u2019ll show what someone\u2019s equity compensation grant actually looks like.\u00a0 From there, we\u2019ll publish some further posts that illustrate tactical considerations around negotiating, managing and exercising those options.\r\n\r\nImage credit: Wikipedia\r\n\r\n__________\r\n\r\n\r\n Study of 24 million 401k plan participants, representing $1.4 trillion in assets by the Employee Benefit Research Institute and the Investment Company Institute (\u201c401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2011\u201d as of December 2012).