Equity Compensation Plans

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While we all want to be paid as high as possible, it is important to realize that compensation can come in more forms than just salary itself.  A potential new hire never has more power when it comes to negotiating salary and compensation than before they accept the position. It is important to realize what is important to them during these negotiations. Negotiating a higher salary always feels good, but there are other factors to consider, such as time off or how to maximize your long-term earning potential at the organization. Remember, the vacation days, especially the first year of vacation, and even the number of days, are both negotiable before accepting the offer. However, having the ability to set yourself up to maximize your long-term earning potential, new hires should always ask for equity compensation plans.

Equity compensation plans are often overlooked because many employees view this as non-cash compensation that can be hard to put a value on when they are received. Technically, they have a point.  This can be especially true for small or startup businesses.  However, if the organization takes off and becomes successful, these can be valuable for those who have received this type of compensation.  The idea of equity compensation is that one more company has started to hire and retain the best employees with strong skills. Non-cash compensations are advantageous to corporations. What that means is the company records an expense on the Income Statement, but these rewards do not include any outflow of cash for the corporation.

In fact, some companies will help execute a sale to cover for the employee when these rewards vest. This is to help cover the income taxes the employee may owe when they do vest. Because upon vesting the equity, compensation is treated as ordinary salary compensation. These rewards also give more employees an actual ownership interest in the company.  The hope is this will provide another tool to improve employee retention. Retaining and attracting highly skilled workers will continue to be challenging, as the workforce continues to lose highly skilled workers due to baby boomers exiting the labor force through retirement. 

What exactly is equity compensation?

There are five basic types of equity compensation plans that employees may see in Corporate America.  The five types are; regular stock options, restricted stock, also called restricted stock units (RSUs or PSUs), stock appreciation rights (SARs), phantom stock, and employee stock purchase plans (ESPPs).  Each of these types of equity compensation is unique, so what is the best option and which type should you want to receive?

Unfortunately, companies usually only offer one of the plans, and all five are not available.  If you want to be part of one plan over the others, you may have to research companies and their plans before applying for employment.  You can look up Publicly Traded Companies by going to www.sec.gov and searching using the company’s stock symbol.  If you read their 10(K) or maybe their Prospectus, you can find out details on the plan(s) the organization offers.

Let’s review and define each type of equity compensation:

Stock Options

Stock Options provide an employee the right to buy a defined number of shares of the company’s stock at a fixed grant or strike price, also called “Exercise Price” after a vesting period. Ideally, it would be at a discount to the current price of the company’s stock. Once you vest that option you can now convert it into stock. Normally, called an “Option Term”.

You can vest stock options in numerous ways. It can be in the form of continuous employment. Certain individuals, teams, to corporate performance metrics can allow for the vesting of stock. The second way is a company may offer employees the option to convert the options into cash or into stock. Companies do not collect anything from employees. Known as a “spread” this is a type of conversion.

Essentially, this would be the difference between the exercise price and the current market value of the stock at the time they are exercised. This can be done without offering anything to the public.  There are other ways to exercise these options without using cash. 

Equity Compensation Plans

The two most common types are only available when you work at a publicly traded company.  They are using a broker, either one provided by the company or an individual broker to execute a same-day sale. Or they can sell-to-cover, that will at the time of conversion sell the stock on the public market to cover the exercise price. Covering any taxes that the employee will owe. Again, these are not available if a Private Company employs you.

Private Companies

Private companies have a few options that they take. First, the company will restrict options from being exercised. Second, they will not sell until the company is sold or decides to go public through an IPO. There are downsides to Stock Options. The first downside is that they may be worthless if the Exercise Price is below the Fair Value at Vesting. If this occurs the recipient does have ten years from the grant date to exercise the options. Which may choose to hold onto the options until the fair value increases over the exercise price.

There are two different types and depending on which type the employee receives the tax consequences are different. First, you have Incentive Stock Options (ISOs) also called Qualified Stock Options. This type may vest either on a schedule over a specific period of time (Graded Vesting). You can also Cliff Vest. Vesting all at once. The employee can choose to exercise all or some of the options once vested. This depends on if the Strike Price is lower than the current value of the stock. The benefit of this reward is the recipient does not owe taxes at the time they exercise the options. Additionally, if the employee waits for one year after they purchase the stock, the gains qualify as Capital Gains. Which is another big tax advantage.  There are no payroll or income taxes due upon exercising these options.

Non-Qualified Options

Non-Qualified Options are another type. This is where the vesting is similar to ISO plans, but the tax consequences are quite different.  When they are exercised, the employee must pay both Income and Payroll Taxes for the difference between the option exercise price and the fair market value of the stock. This difference will appear on the employee’s W-2. Due to paying taxes when exercised the tax basis will be the fair value of the stock when purchased. You can avoid Ordinary Income taxes if you hold them for over a year before selling.

Restricted Stock or Restricted Stock Units (RSUs)

Restricted Stock Units, when exercised, are treated similarly to stock options.  However, they usually allow the employee to receive shares at no cost, except for the amount owed on taxes. This happens when the RSUs are vested or performance requirements are met. Unlike options, which are not. Vesting can occur in two ways. One is by the passing of time when other defined restrictions have lapsed. Two, employees have met performance goals. Continuous employment between three and five years is what defines a time restraint. 

Many corporations today treat RSUs like Phantom Stock. This means that the employee may not have any voting rights that come with being a shareholder. The employee will only get the dividends if they vest their stocks. Dividend participation is the biggest advantage of RSUs.

Obviously, that means the corporation must pay dividends on a quarterly or annual basis.  The payment of dividends is something the organization’s Board of Directors votes on during their quarterly meetings.  Ordinary income rather than capital gain taxes is the downside in this situation. Like true dividends. Which are lower than regular income.

Once vested, the employee can either hold the shares or sell them on the appropriate stock exchange.  Unlike some other forms of equity compensation, RSUs always have some value because of the fact the employee will receive actual shares of the company’s stock upon vesting. The ordinary income rate is the only difference.

Once vested you can calculate the value. Which is usually at the close of the market using the current fair value of the shares.  Unlike options, RSUs always have value because once these vests. That is because the employee receives actual shares of the stock the day they vest. There is no transaction or exchange of cash needed to receive the shares. 

Usually, companies will allow the employee to exchange some shares for covering any taxes.  On the day they exercise, the actual shares received have ordinary income taxes.  Where stock options give the employee the right to purchase but there is no obligation to acquire the shares. However, with RSUs you only earn the shares once you sell them.  Meaning you don’t have to put money to receive the shares. The company will pay you the shares upon the exercise date. Except for the amount equal to taxes owed.

Both Phantom Units and Stock Appreciation Rights (SARs)

Stock Appreciation Rights essentially pay out as a cash bonus based on the value of the company’s stock.  Phantom Units often include Dividend Equivalent Rights, which essentially allow the employee to receive cash dividends prior to vesting.  SARs do not offer this benefit. You can settle this with cash. But some plans will offer settlement in actual stock upon vesting. One thing to note is that ordinary tax rates apply once paid.

Employee stock purchase plans (ESPPs)

are plans that allow employees to set aside money over a period of time through after-tax payroll deductions.  The plan will accumulate these funds. Once accumulated, they will purchase stock for the employee at the end of the offering period at a discount. Usually between 5%-15%.  Some plans will offer a look-back provision. Which allows you to purchase the stock at a lower rate than the current value based on the value of the stock at the beginning of the purchase period. To take advantage of the tax benefits you must hold the shares for two years.

Each plan has its unique characteristics, but the key takeaways from all the plans are:

  • Equity compensation plans are normally non-cash compensation plans offered to employees, except for SARs and Phantom Stock Plans which are often treated as a cash bonus upon vesting.
  • Provides employees a chance to own a piece of the company.
  • The value of equity will grow when the company performs well. Which should cause the employee’s interests to better align with the company’s vision, goals, and objectives.
  • On the negative side, they carry no guarantee the equity stake will actually pay off at vesting.  RSUs are the exception as they will always hold some value at vesting. This is because actual shares will be received, and they will have some value based on their current market conditions.
  • Cost the corporation nothing as the only cash that is exchanged relates to taxes owed by the employees when the rewards vest.  The company may choose to exchange a part of the reward to cover the tax consequences owed by the employee.
  • May include options, restricted stock, performance shares, stock appreciation rights, phantom stock, and employee stock purchase plans.
  • Due to plans carrying different tax consequences, it is always advisable to consult with a tax specialist to make sure you maximize your benefits.
  • For companies that pay dividends, many of the plans will offer DERs prior to the vesting of the rewards.  Essentially allowing the employee to receive the same dividends paid to other shareholders.
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