Equity Compensation: What It Is, Types, Pros & Cons
Understanding the details surrounding your equity compensation can help you make the most of your benefits.
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What is equity compensation?
Equity compensation, also called stock-based compensation, is noncash pay that can provide ownership in an employer. Examples of equity compensation include stock options, restricted stock units (RSUs), employee stock purchase plans (ESPPs) and more. Companies may give equity compensation to employees and sometimes outside service providers, such as contractors, advisors, directors or consultants.
Types of equity compensation
There are many types of equity compensation, and each has unique characteristics.
1. Employee stock options
Employee stock options give you the right (but not the obligation) to buy a certain number of company shares at a fixed price during a specified period. There are two types of employee stock options: incentive stock options (ISOs) and nonqualified stock options (NQOs). Both are usually subject to vesting rules but differ in tax treatments and who is eligible to receive them.
» MORE: Plan for when to exercise stock options
2. Restricted stock units (RSUs)
With RSUs, your company promises to give you a certain number of shares over time (there may be additional conditions to satisfy, too). You do not purchase these shares; they are free to you. However, they count as income in the eyes of the IRS, so they often trigger a tax liability when the shares become yours, even if you haven’t sold them yet. If you sell them for more than they were worth at the time you received them, that gain may also be taxable.
» Ask an advisor: How are RSUs taxed?
3. Restricted stock awards (RSAs)
Restricted stock awards are company shares you can purchase on or after the grant date. However, your rights to the stock are restricted for a certain amount of time (the vesting period). RSAs are generally awarded to early employees of startups, so buying RSAs at fair market value usually means purchasing shares at minimal or no cost, when the company's value is relatively small.
» Ask an advisor: RSUs vs. stock options
🤓 Nerdy Tip
RSUs and RSAs aren’t the same as “restricted stock.” Restricted stock (also called "control stock") refers to shares purchased during a private offering or transaction wasn't registered with the U.S. Securities and Exchange Commission.
4. Employee stock purchase plans (ESPPs)
ESPPs let employees buy company stock at a price below the market price. Often they can do this through after-tax payroll deductions. There are both qualified and nonqualified ESPPs; qualified ESPPs offer preferential tax treatment.
» MORE: How ESPP taxes work
5. Performance shares
If you or the company meets specific performance-related goals, the company may give you performance shares. These awards frequently go to company executives and directors as an incentive to hit performance targets.
6. Stock appreciation rights (SARs)
SARs give you the monetary equivalent of the value of your company’s share price for a set number of shares over a particular period. You may receive this benefit in cash or in company shares.
7. Phantom stock
Also known as synthetic stock or shadow stock, phantom stock mimics the perks of stock ownership without actually receiving company shares. Instead, the value of your phantom stock moves in tandem with the actual company stock price, and you earn cash 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 deferred compensation (see below) rather than an equity compensation.
8. Deferred compensation
Nonqualified deferred compensation plans (also known as supplemental executive retirement plans or elective deferral plans) aren’t equity compensation, but they’re worth mentioning. NDCPs allow employees to postpone income (salary, bonus or other cash payments) to a later date so they can defer the taxes. Also, the income can grow tax-deferred within the plan. Companies may offer NDCPs along with equity compensation, particularly to key employees.
Pros and cons of equity compensation
Boost income with stock-based pay in addition to a salary or other cash compensation.
Share in the company’s growth.
In some cases, receive preferential tax treatment.
Typically require meeting certain conditions, such as abiding by a vesting schedule.
Tax liability may be complex and require planning.
In some cases, may be worthless if the company’s stock doesn’t perform as expected or if you leave before the vesting period is fulfilled.
What to consider about equity compensation plans
Each equity compensation plan’s details and restrictions vary, so it’s essential to read the fine print.
Think about equity compensation when negotiating any pay package. It could boost your overall earnings, but it comes with its own set of risks.
Know the tax consequences that may impact you now and in the future. Equity compensation is often income in the eyes of the IRS, which means you may get a tax bill if you receive shares, even if you haven't sold them yet.
Get a second opinion from a financial advisor who is well versed in equity compensation to ensure you’ve considered all relevant nuances when devising your plan of action.
Learn 5 common restricted stock mistakes investors make, and how to avoid them to help protect your wealth.
on NerdWallet Wealth Partners' website. For informational purposes only. NerdWallet Wealth Partners does not provide tax or legal advice.
Why employers offer equity compensation
Equity compensation can be a nice perk for employees, but it also offers an upside to employers. Employers may offer equity compensation to:
Attract and retain talent. Since the potential for a hefty payout is appealing, companies often use equity compensation to woo top talent. The vesting schedule can also entice workers to stay longer in order to avoid leaving money on the table.
Instill ownership. Having a stake in the company may help align employee goals with employer goals. Because the value of the equity compensation rises when the company’s share price rises, the thinking goes, employees focus more on tasks that increase the value and profitability of the company.
Free up company cash. Companies may offer equity compensation in place of a high salary to help manage their cash flow. This can be especially meaningful to smaller companies and startups with limited cash to attract top talent. Additionally, companies that offer equity compensation may earn a tax credit, minimizing their federal tax liability.
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