Equity compensation offers founders, executives, and key employees an opportunity for significant wealth creation.
However, 82% of employees report that they need help understanding their equity compensation (Schwab Equity Compensation Study).
To help alleviate the anxiety around equity and prevent you from making common equity mistakes that will cost you money, this is my attempt at writing the simplest equity compensation guide you'll ever read.
What is Equity Compensation?
It's part of your compensation package, like your salary, but more complex. Instead of cash, you receive some equity-related benefit.
Companies use equity compensation as an incentive to align employees' interests, keep them motivated, and improve retention of key employees and executives.
Types of Equity Compensation
The most popular forms of equity compensation include:
· Restricted Stock Awards (RSAs)
· Stock Appreciation Rights (SARs)
The type(s) of equity you receive dictate your tax consequences and potential strategies. We'll cover the basics of equity so you have a foundation before getting into more complex monetization planning.
Equity Grants
When a company makes a grant, they're promising to deliver a specified benefit once certain criteria are met.
Grants typically include outright company shares, the option to buy company stock, and other equity-related benefits.. The day you receive a grant is the grant date or issue date.
Receiving a grant is exciting, but you don't really own anything yet. That's why equity grants usually aren't taxed.
Your company wants to make sure you stick around for a while before you can cash in on their promise. So, your equity grant is subject to vesting.
Vesting
Vesting may be the most important equity event.
Think of it as taking ownership of all or a portion of the grant. A grant vests when you meet the vesting criteria.
Vesting is a taxable event for some equity types, so it's important to know the exact criteria to project cash flow, taxes, and liquidity.
The criteria are typically time-based or performance-based.
Time-Based Vesting
Time-based vesting requires you to stay with the company over a vesting schedule. These grants usually have multiple vesting events.
For example, a fraction of the grant vests monthly, quarterly, annually, all at once (cliff vesting), or a combination (one-year cliff, then monthly).
Some private companies issue double-trigger RSUs, which combine time-based vesting with a liquidity event like an IPO or tender offer.
Performance-Based Vesting
Performance-based vesting requires you, your team, or the entire company to hit pre-determined metrics for the grant to vest. These are known as Performance Share Units (PSUs).
For example, team sales, an EBITDA multiple, total company revenue, etc.
If you exceed the metrics, you may receive a multiple of the original grant. If you don't the grant is forfeited.
What Happens After Vesting?
Now that your grant has vested, you own whatever equity benefit the company promised.
For RSUs/PSUs, you immediately take ownership of the shares.
For NSOs/ISOs, you now have an option (the right, but not the obligation) to buy shares at the exercise/strike price.
RSU/PSU Vesting
You're now free to do whatever you want with the shares (subject to company trading restrictions).
Because you own the shares, the value of the grant is taxed as ordinary income.
The taxable value = shares vested*share price at vesting
NSO/ISO Vesting
It's worth repeating that an option gives you the right, but not the obligation to buy company shares.
You aren't taxed when options vest because you don't actually own the underlying shares until exercise.
Let's see what that process looks like.
Exercising Employer Stock Options
When you exercise an option, you buy the shares at the pre-determined exercise/strike price. This price usually equals the stock's Fair Market Value (FMV) on the grant date.
An option is in-the-money when the FMV is greater than the exercise price.
An option is underwater when the FMV is less than the exercise price.
The difference between the FMV and exercise price of an option is known as the bargain element or spread.
When you decide to exercise an in-the-money option depends on a few things, including:
Option type
Your tax situation
Size of bargain element
Exercise/liquidity options
Time value/time until expiration
Tax at Exercise
Tax on the bargain element depends on whether the option is an NSO or an ISO. An NSO bargain element is taxed like your paycheck. ISOs are more complicated.
I cover both in detail in The Executive's Guide to Incentive Stock Option Taxation and The Executive's Guide to Non-qualified Stock Options.
Equity Tax Withholding
Supplemental income is income received in addition to your regular paycheck. Bonuses and equity compensation are considered supplemental income (may exclude ISOs).
This is relevant because supplemental income is taxed at ordinary income tax rates, the same as your paycheck. However, federal taxes on supplemental income are withheld according to a different set of rules.
The IRS requires the first $1M of supplemental income be withheld at 22% and anything >$1M be withheld at 37%. This can leave a gap in tax withholding vs tax liability for high earners.
For example, your household income puts you in the 35% marginal tax bracket. When $200,000 of RSUs vest, this adds $75,000 to your federal tax liability, but only $44,000 in federal taxes are withheld.
Equity Liquidity Considerations
Many employees don't realize that they're responsible for providing cash to pay:
Tax withholding at vesting for RSUs/PSUs
The cost of shares at exercise for ISOs
Tax withholding + the cost of shares at exercise for NSOs.
What if you don't have the cash available? Most people use a cashless exercise, sometimes called "sell-to-cover."
This allows you to receive the net shares after the subtracting the cost of the shares (option) and required tax withholding (RSUs and options). Unfortunately, this is usually only available for shares of publicly traded companies.
Liquidity and exercise options are harder to come by for employees of private companies. Depending on your plan documents and situation, you may have access to:
Stock swaps
Self-financing
Outside financing
Employer financing
These are less common and much more sophisticated scenarios you should review with a professional.
Equity Expires
Remember that your options have an expiration date. This is the deadline to exercise an option, typically 10 years after the grant date. If you fail to exercise before then, the option expires worthless.
Depending on the stock's price, you could lose a lot of value.
Conclusion
Equity compensation has turned ordinary people into multi-millionaires. However, optimal monetization hinges on your and/or your advisor’s ability to minimize taxes and capture upside without concentrating your net worth in company stock.
Understanding your equity compensation is the first step in creating a monetization strategy to achieve your personal and financial goals.
Common Equity Compensation Terms
Fair Market Value (FMV)
If a stock is publicly traded, this is the market price of the stock. The FMV of privately held stock can be obtained through a business appraisal, known as a 409A valuation.
Exercise or Strike Price
This is the price you pay for the stock when you decide to exercise an option. It’s usually equal to the Fair Market Value (FMV) of the stock on the grant date.
For example, your company grants you an option to buy 1,000 shares of company stock when the FMV is $10. If you decide to exercise the option two years later, you'll pay $10/share, regardless of the FMV at the time of exercise.
Bargain Element
If you have an option with a $30 strike price, and the FMV is $50, you can buy the stock for $30 instead of $50 when you exercise. The $20 discount is known as the “bargain element.”
Bargain Element = (FMV – Strike Price)*# of shares
Qualifying Disposition
A qualifying disposition on the sale or transfer of ISO shares must occur more than two years after the grant date and more than one year after the exercise date.
For ESPPs, the criteria is more than two years from the offer date and more than one year from the purchase date.
Anything outside these parameters is a disqualifying disposition.
Disclaimer
Unrivaled Wealth Management (“UWM”) is a registered investment advisor offering advisory services in the States of Pennsylvania, Ohio, and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training.
This communication is for informational purposes only and is not intended as tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement of any company, security, fund, or other securities or non-securities offering. This communication should not be relied upon as the sole factor in an investment making decision. Past performance is no indication of future results. Investment in securities involves significant risk and has the potential for partial or complete loss of funds invested. It should not be assumed that any recommendations made will be profitable or equal the performance noted in this publication.
The information herein is provided “AS IS” and without warranties of any kind either express or implied. To the fullest extent permissible pursuant to applicable laws, Unrivaled Wealth Management, LLC (referred to as “UWM”) disclaims all warranties, express or implied, including, but not limited to, implied warranties of merchantability, non-infringement, and suitability for a particular purpose.
All opinions and estimates constitute UWM’s judgement as of the date of this communication and are subject to change without notice. UWM does not warrant that the information will be free from error. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information is at your sole risk. Under no circumstances shall UWM be liable for any direct, indirect, special or consequential damages that result from the use of, or the inability to use, the information provided herein, even if UWM or a UWM authorized representative has been advised of the possibility of such damages. Information contained herein should not be considered a solicitation to buy, an offer to sell, or a recommendation of any security in any jurisdiction where such offer, solicitation, or recommendation would be unlawful or unauthorized
Comments