Why do companies offer equity compensation?
Equity compensation is used by many types of employers. Most startups use equity compensation to reduce their burn rate while keeping their compensation competitive. As a company matures and cash compensation becomes less problematic, many companies continue to offer equity compensation to align their employees’ interests with those of the company.
The four main classes of equity compensation
First, and most common, are Restricted Stock Units, which we covered in an earlier article. Second, many employers offer the benefit of purchasing company stock at a discount through an Employee Stock Purchase Plan (ESPP). To contribute to an ESPP, employees will take salary deductions and the company will purchase its own shares on the employee’s behalf. Along with a discounted price, some employers offer a “look back option”, which allows you to dictate whether you want to purchase the stock on the first or last day of the offering period (whichever price is lower).
The third class is Non-Qualified Stock Options (NSOs), which tend to be less complex and the more common type of stock options. The “Non-Qualified” part of the name refers to the fact that NSOs don’t meet all the criteria set by the Internal Revenue Code to be classified as incentive stock options (ISOs) which we will cover shortly. Essentially, there are less restrictions surrounding NSOs making them less sophisticated and more widely used. Unlike ISOs, the employee will pay ordinary income tax on the difference between the strike price, or grant price, and the market value at the exercise date. Upon exercising the options, the employee can sell immediately or hold the stock. If the shares are sold immediately, the employee will pay short term capital gains, or report a loss on the sale. If the employee waits to sell the shares, the changes in the Fair Market Value (FMV) of those shares will determine the future taxes the employee will owe. A good resource with examples to better understanding the tax ramifications of NSOs can be found on Intuit’s Non-Qualified Stock Options page.
Finally, Incentive Stock Options (ISOs), which are qualified stock options, are less common for employees to see, and can be considered tax advantaged over NSOs. ISOs are generally awarded to executives or senior employees to incentivize them to stay with the company. Also, companies implement ISOs to attract new talent when they can’t pay a competitive salary solely with cash. ISOs are granted at a price set by the employer, which is generally an approximation of what the shares are worth at that time. The grant date, is followed by the exercise date, at which point, the employee exercises the options and they can sell immediately or wait for a more desirable time. The employee must wait at least 1 year from the exercise date and at least 2 years from the grant date to have their gains treated as capital gains, which is the favorable tax treatment that ISOs provide to employees. In contrast with NSOs, ISOs only have one taxable event: the point of sale (there is no taxable event upon receipt of ISOs). The offering period for ISOs is always 10 years, and after those 10 years have passed, the options expire worthless. Some more details of the tax treatment of ISOs can be found on Intuit’s Incentive Stock Options page.
One important thing to remember about stock options is that they are only valuable when the current market price is above the strike price. If the current market price has fallen below the strike price, then they have no intrinsic value and cannot be exercised until the market price exceeds the strike price.
That covers the four main types of equity compensation. All four can be great benefits to employees. To get the most out of equity compensation, you need to understand the details of your personal situation. Your financial advisor can help you make an informed decision.
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