The Power of Equity Compensation
Equity compensation packages offer founders, executives, and key employees an opportunity for significant wealth creation. Unfortunately, the complexity of forming an optimal monetization strategy can result in analysis paralysis or uninformed monetization decisions that lead to thousands, even millions, of dollars lost to handicapped upside and avoidable taxation.
What is Equity Compensation?
Companies use equity compensation as an incentive to align employees' interests, keep them motivated, and improve retention of key employees and executives. In return, employees receive discounted and sometimes free shares of company stock, which allow them to participate directly in the company’s growth.
Types of Equity Compensation
The most popular forms of equity compensation include:
· Incentive Stock Options (ISOs)
· Restricted Stock Awards (RSAs)
· Stock Appreciation Rights (SARs)
· Employee Stock Purchase Plans (ESPPs)
Each equity arrangement has nuances that dictate tax consequences and potential strategies. However, there are critical terms that must be understood before trying to create a monetization strategy. That’s what we’ll dive into here.
Equity Compensation Terms
When a company makes a grant, they're promising to deliver a specified benefit once certain criteria are met. Grants typically include company shares, stock options, and other equity-related benefits. The day you receive a grant is the grant date or issue date.
Supplemental income is income received in addition to your regular paycheck. Bonuses and equity compensation are considered supplemental income.
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%.
Substantial Risk of Forfeiture
A grant does not equal ownership because grants are subject to a substantial risk of forfeiture. Put simply, the grant can be taken away. For some equity types, there is no longer a risk of forfeiture once vesting criteria are met. However, unexercised options and other equity grants can still be revoked after vesting, depending on your employment terms and equity plan specifics.
The most common requirement is continued employment over a period of time. However, 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.
Performance Share Units (PSUs) criteria can comprise individual, team, or company performance metrics for the grant to vest.
Most grants have multiple vesting events; the specific vesting schedule depends on your plan agreement. Grants can vest monthly, quarterly, annually, etc., over several years, all at once (cliff vesting), or a combination of cliff and graduated vesting.
What does vesting mean for you?
As mentioned, vesting is a taxable event for some equity types, like RSUs, because you immediately receive company shares. In other cases, it's not a taxable event because you only received the option to exercise a benefit, like NSOs and ISOs.
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.
An option gives you the right, but not the obligation, to buy stock at a set price in the future. When you decide to buy the stock, you're exercising the option.
Remember, the option must vest or be vested before you can exercise it.
The two types of stock options (ISOs & NSOs) are similar in many ways, but the key differences require a more detailed explanation of each.
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.
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.
We've already explained what it means to exercise an option, but now we need to know how things unfold at exercise.
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. The $20 discount is known as the “bargain element.”
Bargain Element = FMV – Strike Price
Tax on the bargain element depends on whether the option was an NSO or an ISO.
Non-qualified Stock Options (NSOs)
The bargain element of an NSO is taxed as earned income, like your paycheck, and withheld as supplemental income. For a detailed explanation of NSOs, read The Executive's Guide to Non-qualified Stock Options (NSOs).
Incentive Stock Options (ISOs)
At exercise, the bargain element is not considered for ordinary or employment taxes but is included in the Alternative Minimum Tax (AMT) calculation. However, the final tax outcome depends on whether the shares are sold in a qualifying disposition or disqualifying disposition. ISOs will be discussed in more detail in a separate post, but it's recommended you work with a qualified tax and financial professional to evaluate your options.
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.
Anything outside these parameters is a disqualifying disposition and will carry various tax consequences.
Sometimes called “sell-to-cover,” a cashless exercise is only available for shares of publicly traded companies.
Some behind-the-scenes logistics by the broker-dealer allow you to exercise an option and receive the net shares after subtracting the total cost of the shares and required tax withholding. Without a cashless exercise, you are required to provide the cash for purchase and withholding.
This is the deadline to exercise an option. If you fail to exercise before then, the option expires worthless. Depending on the stock's price, you could lose a lot of value.
Equity compensation has turned ordinary people into multi-millionaires. However, optimal monetization hinges on your or your advisor’s ability to minimize taxes and capture upside without concentrating your net worth in company stock.
Understanding the key terms associated with the various forms of equity compensation is the first step in creating a monetization strategy to achieve your personal and financial goals.
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