What Is Equity Compensation?
What Is Equity Compensation?
A Guide for Tech Employees
RSUs, ISOs, NQSOs, and ESPPs all work differently, and each is taxed on its own timeline. Here's how to make sense of your grant before you make a move.
Equity compensation is non-cash pay that gives employees an ownership stake in their company, typically through stock options, restricted stock units (RSUs), or an employee stock purchase plan (ESPP). Instead of relying on salary alone, employees build wealth as the company's stock value grows, which is why an early startup hire can walk away with a grant worth 2 to 3% of the company, sometimes worth millions if the company exits well.
For tech professionals, equity compensation is often the single largest, and most misunderstood, piece of total compensation. Getting the mechanics and the tax treatment right can mean the difference between a life-changing outcome and a costly mistake.
What Is Equity Compensation and How Does It Work?
Equity compensation is a form of non-cash pay that gives employees partial ownership in their employer, aligning their financial interests with the company's shareholders. Startups and growth-stage tech companies use it heavily to attract and retain talent without straining cash flow.
Most equity compensation is subject to a vesting schedule, a set period an employee must stay at the company before they fully own their grant. Vesting encourages retention and typically follows either cliff vesting (all shares vest at once after a set period) or graded vesting (shares vest incrementally, often monthly or quarterly, over three to five years). For a closer look at how these grant types stack up against each other, see our full breakdown of types of equity compensation.
| Type | Description | Benefits | Drawbacks |
|---|---|---|---|
| Stock Options | The right to buy company shares at a fixed exercise price, subject to vesting | Significant upside if the stock appreciates | Can end up worthless ("underwater") if the stock price falls below the exercise price |
| RSUs | Actual company shares granted outright once vested | No exercise cost; shares always have value as long as the stock does | Full tax liability hits immediately at vesting, with less flexibility to manage timing |
| ESPP | Payroll-deducted purchases of company stock, often at up to a 15% discount | Built-in discount creates an immediate paper gain | Purchase windows are rigid and can strain short-term cash flow |
How Do Stock Options Work?
Stock options give employees the right, not the obligation, to buy company stock at a fixed exercise price (also called the strike price), typically set at fair market value on the grant date. Companies issue two types: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs).
ISOs offer preferential tax treatment: profits can qualify for long-term capital gains rates instead of ordinary income tax, provided the employee meets specific holding period requirements (shares held more than one year from exercise and two years from grant). The tradeoff is that exercising ISOs can trigger the Alternative Minimum Tax (AMT) in the year of exercise, even before any shares are sold.
NQSOs are more broadly granted and don't qualify for long-term capital gains treatment on the spread. When an employee exercises NQSOs, the difference between fair market value and the exercise price is taxed immediately as ordinary income.
If the stock price falls below the exercise price, the options are considered "underwater" and hold no immediate value, since new grants would carry a lower strike price. Employees should understand their vesting schedule, exercise deadlines, and tax exposure before exercising, which is where Brooklyn Fi's stock options planning comes in.
ESPPHow Do Employee Stock Purchase Plans (ESPPs) Work?
An ESPP lets employees buy company stock through payroll deductions, typically at a discount of up to 15% off fair market value. ESPPs generally follow a four-step structure:
Enrollment: Employees elect a percentage of salary to contribute, usually capped at 20 to 25%, deducted on a post-tax basis.
Offering period: Contributions accumulate over a set window, commonly six months, often split into quarterly purchase periods.
Purchase price: Set at a discount to fair market value, applied to whichever is lower, the price at the start or the end of the offering period.
Purchase: At the end of each purchase period, accumulated funds buy shares on the employee's behalf at the discounted price.
The built-in discount creates an immediate paper gain, and further upside follows if the stock appreciates after purchase. Platforms like Fidelity Stock Plan Services, E*Trade, Schwab Equity Award Center, and Carta commonly administer ESPPs and equity plans on the employer's behalf.
RSUsHow Do RSUs Work?
RSUs grant employees company shares once specific conditions are met, most commonly a time-based vesting schedule. Unlike Restricted Stock Awards, which confer immediate ownership, RSUs represent a contractual right to receive shares in the future; nothing is owned until vesting occurs.
Typical RSU vesting schedules run three to five years, structured as either cliff vesting or graded vesting. Employees who leave before their RSUs vest generally forfeit the unvested portion, though some companies include accelerated vesting provisions for events like retirement, disability, or acquisition.
RSUs are taxed as ordinary income at vesting, not at grant, and this is the single most important fact to understand about RSU taxation. The employer typically withholds a portion of the vesting shares to cover the tax bill. Private companies that haven't gone public often can't create a market for employees to sell shares to cover taxes, so many structure RSUs with a double-trigger provision: shares vest and become taxable only once both the time-based schedule is met and a liquidity event (acquisition or IPO) occurs.
RSUs have a reputation as the simplest form of equity compensation, but that reputation causes real mistakes. See our breakdown of common RSU misconceptions.
TaxationHow Is Equity Compensation Taxed?
The tax treatment of equity compensation depends on the type of grant and how long shares are held, and typically falls into one of three buckets: ordinary income tax, the Alternative Minimum Tax (AMT), or capital gains tax (short or long term). RSUs are taxed as ordinary income at vesting. ISOs may trigger AMT at exercise depending on income level, and NQSOs are taxed as ordinary income at exercise.
Vesting timing drives when each tax hits. RSUs are taxed at vesting, NQSOs are taxed at exercise, and ISOs may generate AMT at exercise and capital gains at sale, contingent on holding periods and whether the disposition is qualifying or disqualifying.
These tax events don't all land at the same time or in the same form. Some are covered by automatic share withholding; others require cash on hand. Key concepts to track include cost basis, MAGI, and net investment income tax, all of which affect the total tax bill on an equity award.
Because equity compensation intersects vesting schedules, AMT exposure, concentrated stock risk, and sometimes SEC Rule 10b5-1 trading plans, most tech employees benefit from a coordinated tax and investment strategy rather than handling each grant in isolation.
FAQFrequently Asked Questions
Questions about your equity compensation strategy?
Whether you're weighing an ISO exercise, timing an RSU sale, or trying to figure out how ESPP contributions fit your cash flow, a fee-only fiduciary can help you build a plan around your specific grants.
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