Equity compensation is an alternative compensation strategy designed to provide employees with investment opportunities through company-based stock options. Over the years, this strategy has become more popular. In fact, according to Harvard Law School, roughly 58 percent of CEO compensation is a mix of equity and cash as of 2019.1
An equity compensation strategy is typically utilized in businesses seeking growth without drawing on a larger budget. This creates long-term ownership incentives at the cost of some income stability. Let’s dive into how equity compensation works and examine some of the different options available to employees.
What Is a Vesting Schedule?
Equity compensation typically comes with a vesting schedule, a period of time in which stocks fully become yours. This schedule will depend on the company and equity type. Some companies may not require a vesting schedule, though this is either a business choice or a result of their available stock option.
Types of Equity Compensation
Each equity option has a different set of opportunities, costs and taxes associated with it. Also, be aware of the term “exercise,” as this is used often in equity compensation and stocks, but actually refers to purchasing a stock.
Consider these differences when deciding whether equity compensation is right for you.
With stock options, you will have the opportunity to purchase a limited number of stocks at a reduced price. After your vesting period, these stocks fully become yours, allowing you to keep or sell them. Be aware, stock options are typically available for a limited amount of time and follow different tax rules between pre-vested and vested stocks. It’s important to note that an employee is not considered a stockholder if they take this option.
Non-Qualified Stock Options (NSOs)
Non-qualified stock options are similar to standard stock options, but with a few tax differences for employees. Owners of NSOs may have to pay taxes under two circumstances:
- Income tax when they purchase a non-qualified stock.
- Capital gains tax if the stock is held for a year or more.
Like non-qualified stock options, incentivized stocks are similar in function to standard stock options, with a different set of tax rules. You will only need to pay capital gains taxes on this stock if it is sold after a set window of time. Otherwise, you may come across additional tax penalties.
Unlike other stock options, which you may receive before your vesting schedule provides full control, restricted stocks are limited by the employer based on your vesting schedule. Instead, you will receive these stocks when they vest. The rate at which restricted stocks are received will depend on the company, just as the vesting schedule does.
As the name implies, employees receive performance-based stocks according to a set of goals. These goals may vary and will depend on your company.
Understanding the differences between stocks can help you determine the value and tax implications of equity compensation. Remember to keep this list in mind when offered stock options by an employer. If you’re unsure of what the best move may be for your current and future financial needs, your financial advisor or partner can help unpack your options.