When TCI was founded in 1990, it was built on a foundation providing investor education. Founder, Bob Swift, believed that informed investors make better decisions and experience greater fulfillment along their financial journeys.
Around that same time, a new form of employee compensation began to gain traction: equity compensation. Over the years, equity compensation has become a common benefit for employees. Yet, despite more employees receiving this form of compensation, many individuals lack a clear understanding of how it works and how it fits into their broader financial and life goals.
In the spirit of education and informed investing, let’s step back and take a broader look at equity compensation.
What Is Equity Compensation?
Equity compensation is a type of non-cash compensation offered to employees of a company. Equity compensation may be available to all employees or only to certain groups of employees depending upon the employer and the type of equity compensation.
There are two categories that equity compensation falls into: employer-granted equity and access to participate in an equity program.
Employer granted equity comes in the form of Restricted Stock Units/Awards (RSUs/RSAs), Non-Qualified Stock Options (NQSOs), Incentive Stock Options (ISOs), and Stock Appreciate Rights (SARs). These forms of equity are granted or given to you by your employer, typically in lieu of a cash bonus.
Employers may also allow employees to choose to participate in an equity program through an Employee Stock Purchase Plan (ESPP). Companies set up these types of programs so that more employees have the option to participate in owning shares of the company they work for.
Why Do Companies Offer Equity Compensation?
The various types of equity compensation provide employees with an ownership stake in the company and a vested interest in the company’s success. According to Morgan Stanley’s State of the Workplace Financial Benefits Study in 2024, 80% of employees and 95% of HR leaders agree that equity compensation remains perhaps the most powerful tool to build a culture of ownership and loyalty among employees.
The Morgan Stanley study of 1,000 companies and 600 HR executives also showed that 72% of the companies surveyed offered some sort of equity compensation, up slightly from the 2023 study.
A factor that is considered a downside by some is the need to meet time of employment or other requirements to realize the full value of your equity compensation. Known as vesting, equity compensation generally requires you have a minimum period of service with the company to receive the full value of the equity compensation. This is referred to as “golden handcuffs.”
How Does Vesting Work?
Vesting is the process through which an employee gains the right to be able to exercise or have outright ownership of certain assets. In the case of equity compensation, you typically do not have immediate ownership nor control over the equity compensation vehicle and the underlying shares. Becoming vested in the award you were granted involves the passage of time or the achievement of some sort of performance-based goal.
Companies use vesting in conjunction with equity compensation for several reasons including:
- Employee retention. Vesting can serve as a major incentive for employees to stay with an employer for the long-term to be able to realize the full value of your equity compensation.
- Vesting provides an incentive for you to focus on the company’s long-term growth since this can help increase the value of their shares that are tied to their equity compensation.
Each company plan typically has a vesting schedule. Some typical vesting schedules are:
- Time based. You must remain with your employer for a specified amount of time for your shares to be vested. Often this is a gradual vesting period with portions becoming vested on a gradual basis.
- Performance based. Some companies may employ a vesting schedule that ties the vesting of your equity compensation to specific performance goals or milestones.
The vesting schedule is important for several reasons. Whether the vesting schedule is based on your tenure with the company or some sort of performance metric, you will not be able to access your equity compensation until the vesting requirement is met. This can impact a potential career move. If you were to leave your company prior to any vesting date, you would forfeit the unvested equity.
Making Sense of Stock Options and RSUs
The two most common types of equity compensation that companies grant to their employees are Restricted Stock Units (RSUs) and Stock Options. Both types of equity compensation have their own nuances and rules.
Stock options
Stock options offer you the right, but not the obligation, to purchase a specified number of shares at an agreed upon price, known as the strike or exercise price. There is generally a vesting period that must be satisfied before you can purchase or exercise the shares.
The two main types of stock options are:
- Incentive stock options (ISOs) can only be granted to employees. If purchased and certain holding requirements are met, gains from ISOs are treated as long-term capital gains. To get the preferential tax treatment, shares must be sold at least two years from the option grant date and one year after exercising the options. While beyond the scope of this blog, be careful when purchasing ISO shares because there are nuanced tax implications (Alternative Minimum Tax) as well as potential risks (becoming overly concentrated).
- Non-qualified stock options (NQSOs) can be given to non-employees such as contractors and directors as well as to employees. When NQSOs are exercised, the difference between the strike price and the price at which you sell is counted as Ordinary Income. This can lead to a substantial jump in income depending on how large of a spread there is between the strike price and the price the stock is sold.
Stock options can be a bit tricky since there is a fixed price (the strike price) at which shares must be purchased.
- If the value of the stock is above the strike price, then your options are “in-the-money,” and they have a value.
- If the current share price is below the strike price, then your options are deemed to be “underwater” and do not have any value. If the price stays below the strike price through the expiration date your options will expire, and it will be as if you never received this equity compensation.
Stock options have an expiration date, typically 10 years from the date on which they were granted. This means that there is an imposed timeline on when you have to make a decision on what to do with them and the failure to do so means that you lose any potential benefit.
There are several timing aspects involved with stock options, they each have different tax nuances, and they can all impact your long-term financial plan. That’s why working with a firm like TCI can help you navigate these complexities and make the most of your equity compensation.
Restricted stock units (RSUs)
RSUs are different from stock options in that RSUs are a grant of an amount of stock versus an option giving you the right to purchase shares at a specified price. With RSUs, you receive either a specified number of shares or a cash equivalent after they have satisfied the vesting requirements.
There is no tax when RSUs are granted, however when the RSUs begin to vest, there is an ordinary income tax component associated with the vesting event. After the shares vest, there is the potential for a second level of taxation, based on how the stock performs and the length at which you hold it from the date of vesting.
For a more in-depth review please see our blog post dedicated to RSUs.
Employee Stock Purchase Plans (ESPPs)
ESPPs are another form of stock compensation, but they differ from stock options and RSUs in that you participate in a program versus receiving grants of the options or RSUs.
ESPPs are similar in structure to a 401(k) in that you can choose to have an amount deducted from your paycheck to contribute to the plan. The money that you allocate to the ESPP plan is then used to purchase shares at specific times as outlined by the plan.
Many ESPPs offer an incentive to employees to participate by discounting the share purchase price by as much as 10% to 15%! ESPP plan structures can vary dramatically from company to company, and it is important to know and understand how your plan is structured as it can have a large impact on the decision to participate and how much you should participate.
A comprehensive review of ESPPs can be found on our dedicated ESPP page.
Finding The Right Equity Compensation Partner
Equity compensation can be a substantial benefit in many cases, especially if the employer’s stock is an appealing investment. However, it’s not quite that simple. Different types of equity compensation will have different implications on your financial plan and your tax planning. Additionally, vesting requirements may influence career decisions.
At TCI, we’re here to educate you and guide you toward decisions that align with your long-term goals. Our expertise in equity compensation allows us to objectively assess your position, modeling different scenarios for exercising and managing your shares. Equity compensation is complex, let us help you make the most of it
This material has been prepared for informational purposes only and is not intended to provide or to be relied upon as tax advice. TCI is neither a law firm, nor a certified public accounting firm, and no portion of its services should be construed as legal or accounting advice. No client or prospective client should assume that any information contained herein serves as the receipt of, or a substitute for, personalized advice from TCI, or from any other investment professional.
