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It’s great to receive equity compensation. It’s even better if you know how to maximize that benefit. But with so many different types of equity compensation plans, it’s important to understand their differences so you can start on the right foot.
What is equity compensation?
Equity compensation, also called stock-based compensation, refers to various noncash remuneration received as part of a pay package. Examples include stock options, restricted stock units, employee stock purchase plans and more. In addition, equity compensation can be given to employees and sometimes outside service providers (contractors, advisors, directors, consultants), providing an ownership stake in the company. The amount of compensation received is typically aligned with the value of the company’s stock.
Why employers issue equity compensation
Having an ownership interest in the company may help to align your incentives with that of your employer. Because the value of your equity compensation increases with the growth of your company’s share price, the thinking goes, you’ll have extra motivation to enhance productivity and stay committed to your company for the longer term.
Since the potential for a hefty payout is appealing, equity compensation benefits are often used to attract and retain top talent. However, you’ll generally have to meet certain conditions to earn your reward, such as abiding by a vesting schedule. This means you’ll need to stay employed with the company for a set time before your ownership rights commence. Also, there is always the possibility that the windfall you’re hoping for never comes to fruition.
Companies may offer equity compensation in place of a high salary to help manage their cash flow. Reducing the amount paid out in cash can be especially meaningful to smaller companies and startups that may have limited cash on hand to attract top talent. Additionally, companies that offer equity compensation may earn a tax credit, minimizing their federal tax liability.
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Types of equity compensation plans and benefits
There are many types of equity compensation and each has its unique characteristics and preconditions to meet.
Employee stock options. Stock options give you the right to exercise or purchase a certain quantity of company shares at a designated price during a specified period if you’d like to do so. There are two types of employee stock options: incentive stock options and nonqualified stock options. Both are usually subject to vesting but differ in tax treatments and who is eligible to receive them.
» Got options? Plan for when to exercise stock options
Restricted stock units, or RSUs. With RSUs, your company grants you a certain number of company shares upon vesting (though there may be additional conditions to satisfy). Unlike stock options, employees do not need to pay for company shares after restrictions, but the vesting date triggers a tax liability.
RSUs differ from restricted stock awards, or RSAs, which are company shares doled out on the grant date (without a vesting requirement). Though employees gain ownership upon granting, they may still need to purchase the shares, hence being called “restricted.” However, since RSAs are generally awarded to early employees of a budding company, purchasing at fair market value usually means purchasing shares at minimal or no cost.
However, don’t confuse RSUs and RSAs with “restricted stock.” Restricted or control stock refers to securities acquired in a private offering or transaction that are not registered with the Securities and Exchange Commission and are entirely unrelated to equity-based compensation. Often restricted stock is held by officers or “control persons” who can significantly impact the company’s direction or have access to insider information. These shares are also subject to resale restrictions under SEC Rule 144.
Employee stock purchase plans, or ESPPs. ESPPs provide employees with the opportunity to purchase shares of company stock at a discount from fair market value, commonly through after-tax payroll deduction. There are both qualified and nonqualified ESPPs; qualified ESPPs offer preferential tax treatment, though a holding or vesting period may be required.
Performance shares. Upon meeting specific performance-related goals, you may attain performance shares. These awards are frequently allocated to company executives and directors as an incentive to achieve particular performance targets.
Stock appreciation rights, or SARs. SARs are a contractual agreement similar to a stock option agreement in that you are given the right to take advantage of your company’s share price increase over a particular period. However, unlike options, you don’t need to purchase the shares and you can opt to receive a cash payment instead of actual shares if you wish.
Phantom stock. Also known as synthetic or shadow stock, phantom stock is a contract that mimics the perks of stock ownership without actually receiving company shares.
The value of your phantom stock moves in tandem with the actual company stock price, and you’ll earn cash rewards based on how much your phantom shares appreciate over time.
Though phantom stock is based upon a company’s equity or share price, technically, these plans are considered a type of nonqualified deferred compensation plan (see below) rather than an equity-based compensation plan.
Deferred compensation. Though not equity-based compensation plans, nonqualified deferred compensation plans (also known as supplemental executive retirement plans or elective deferral plans) are worth mentioning. NDCP plans can be offered along with other forms of equity compensation, particularly to key employees. NDCPs allow employees to postpone income (salary, bonus or other eligible cash payments) to a later date. Doing so can help employees target specific future goals and put taxes off later as the income grows tax-deferred within the plan.
What to consider about equity compensation plans
There are various types of equity compensation plans. Each plan’s details and restrictions vary, so it’s essential to take the time to read through all of the fine print. This way, you can prepare for any financial and tax consequences that may impact you now and in the future. In addition, seeking a second opinion from a financial or tax advisor well versed in equity compensation can help ensure you’ve considered all relevant nuances when devising your plan of action.