What is Equity Compensation? The Tech Employee's Pocket Guide
Think a measly salary is all you can hope for in a tech job? Think again. The first hire at a Silicon Valley startup can get up to 2-3% equity—which could be worth millions down the road. Intrigued yet? Read on to learn how equity compensation can help you hit the jackpot.
What Is Equity Compensation and How Does It Work?
Equity compensation is a non-cash form of payment offered to employees, which may include various types of company stock. It allows employees to directly benefit from the company's success while aligning their interests with the company's shareholders.
We often see equity compensation offered by startups and other businesses aiming to entice new talent or retain experienced employees. One of the most common forms of equity compensation is the employee stock option. This grants the employee the right to purchase company stock at a predetermined price (also known as the exercise price or current fair market value). Employees can potentially profit from this if the stock price goes up over time. Incentive and non-qualified stock options are two types of employee stock options with varying tax implications and eligibility requirements.
Equity compensation also typically comes with a vesting schedule, meaning that employees must remain with the company for a certain period before they can claim their equity. This encourages employee loyalty and long-term commitment to the company.
| Type | Description | Benefits | Drawbacks |
|---|---|---|---|
| Stock Options | Stock options grant the right to buy company shares at a fixed price (exercise price), typically subject to a vesting schedule | Potential for significant financial gains if the company's stock value increases. | The value of stock options can fluctuate and may end up worthless if the stock price doesn't rise. |
| Restricted Stock Units (RSUs) | RSUs are actual company shares granted to employees, typically subject to a vesting schedule. | Provides ownership in the company, also eliminates the risk of stock options becoming worthless since RSUs already represent company shares. | Lack of flexibility in managing tax liabilities, as tax obligations are immediate upon vesting. |
| Employee Stock Purchase Plan (ESPP) | ESPP allows employees to purchase company shares at a discounted price during specific periods. | Offers an opportunity to buy company stock at a discount, creating an instant paper gain. | Limited purchase windows are restrictive and can cause cashflow issues |
Stock Options
Stock options allow employees to purchase company stock at a predetermined price, allowing them to benefit from the company's growth. Companies can offer employees two types of stock options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs).
Incentive Stock Options (ISOs) offer certain tax advantages but also come with tax pitfalls. Profits from previously exercised ISOs could be treated as long-term capital gains if specific holding period requirements are met. This long-term capital gain tax rate is often lower than the ordinary income tax rate. But exercising ISOs could trigger Alternative Minimum Tax in the year of exercise.
On the other hand, Non-Qualified Stock Options (NQSOs) are more commonly offered to a broader range of employees and do not have the same long term capital gain treatment as ISOs. When NQSOs are exercised, the difference between the stock's fair market value and the exercise price is treated as ordinary income.
The exercise price, also known as the strike price, is the set stock price at which employees can purchase shares. In most cases, companies set the exercise price at the stock's fair market value when the options are granted. By locking in this price, stock options allow employees to buy the company's stock at a discounted price if the stock's value rises, potentially leading to significant profits. If the stock’s value falls below the exercise price then those stock options are “underwater” and are effectively worthless since any new grants of stock options will have the lower current price.
Stock options generally have a set vesting schedule determining when employees can exercise their options and purchase shares. Once the grants have vested and the employee decides to exercise them, they'll pay the predetermined exercise price to acquire the actual shares. Employees need to understand their vesting schedule and potential tax implications before making any decisions regarding their stock options. This is where BKFi can help!
Employee Stock Purchase Plans (ESPP)
Employee Stock Purchase Plans (ESPP) are another type of equity compensation companies can offer employees. These plans allow employees to purchase company stock, typically through payroll deductions, at a discount from the fair market value.
ESPPs typically work as follows:
Enrollment Period: At the start of the offering period, employees choose what percentage of their salary they want to contribute to the ESPP. This money is often deducted from their paycheck on a post-tax basis.Typically we see limits of 20-25% of salary.
Offering Period: The offering period usually lasts for six months, during which the payroll deductions are made. Some plans include purchase periods within the offering period, usually at the end of each quarter, where the accumulated funds are used to purchase stock.
Purchase Price: The purchase price for the stock is usually set at a discount to the fair market value, often up to 15%. The discount is applied to the stock price at the beginning or the end of the offering period, whichever is lower.
Purchase of Stock: At the end of each purchase period, the company uses the accumulated funds to purchase shares on the employee's behalf at a discounted price.
ESPPs offer employees a potentially advantageous way to invest in their company. The discount on the share price can provide an immediate return on investment, and if the company's stock price rises, the gains can be significant.
Restricted Stock Units (RSUs)
RSUs are a type of equity compensation that grants employees the right to receive company shares after meeting certain conditions, primarily based on a vesting schedule. The term "restricted" refers to these conditions, typically including a vesting period or achieving specific performance targets. The main difference between RSUs and Restricted Stock Awards is that RSUs represent a contractual right to receive shares in the future. In contrast, Restricted Stock Awards provide immediate ownership of the shares.
Vesting periods play a crucial role in RSUs. The specified period must elapse before an employee gains full access to the granted shares. Companies establish varying vesting schedules depending on their preferences. Typical vesting schedules range from three to five years and can be structured as cliff vesting, where all shares vest at once, or graded vesting, where shares vest incrementally over time.
Regarding transferring and leaving a company, RSUs have some specific rules. Generally, employees who leave the company before the vesting period is complete forfeit any unvested RSUs. However, provisions for accelerated vesting may exist in the case of termination due to events such as retirement, disability, or the company being acquired.
Lastly, taxation is an essential aspect to consider when dealing with RSUs. Unlike stock options, employees pay taxes on the value of the RSUs at vesting, not when they are granted. The income generated from RSUs is subject to ordinary income tax rates, and the company usually withholds a portion of the shares to cover the tax liability. If the company is still privately owned, there may not be a market to sell the shares into to cover the taxes so often companies will grant RSUs with a “double trigger” provision so that the shares are only received (and taxed) when there is an acquisition or IPO. RSUs are touted as the easiest form of equity compensation but are often misunderstood.
Learn more about RSU misconceptions.
How Does Equity Compensation Affect My Taxes?
First, the type of equity compensation you receive and the duration you hold the shares can determine whether you'll owe ordinary income tax, alternative minimum tax (AMT), or capital gains tax (short- or long-term). For example, restricted stock units (RSUs) are generally considered taxable income when they've vested, whereas incentive stock options (ISOs) are subject to the AMT, depending on your income levels.
Another aspect to consider is the vesting period. It's essential to understand that equity compensation is usually subject to a vesting schedule – meaning you'll gradually earn the right to own the shares over time. As your equity vests, you may experience taxes with different consequences. For instance, RSUs are taxed at the time they're vested, while non-qualified stock options (NSOs) are taxed when you exercise them.
When managing your equity compensation, accounting for cash flow requirements is crucial. Since various forms of equity compensation may result in tax liabilities at different times, you'll need to ensure you have the cash to cover these payments when they're due.
Ultimately, navigating the world of equity compensation and its tax implications can be complex. It's crucial to understand the various tax consequences and make informed decisions when managing your equity awards to make the most of your total compensation package.
Frequently Asked Questions
How does equity compensation differ from stock options?
Equity compensation is a broader term encompassing various types of non-cash pay, including stock options. Stock options, on the other hand, are a specific type of equity compensation that provides employees the right, but not the obligation, to purchase company shares at a predetermined price after a vesting period source.
Is it better to take equity or salary?
The decision to take equity or salary depends on an individual's financial goals and risk tolerance. Equity compensation can offer potential long-term value and wealth-building opportunities but comes with higher risks. Conversely, salary provides immediate cash compensation and lower risk. Weighing the pros and cons of each and considering personal factors is crucial to making the right choice.
Watch our webinar on how to negotiate for equity and salary.
How is equity compensation typically paid out?
Equity compensation is generally paid based on a vesting schedule, which establishes when employees can exercise their options or become the outright owners of the granted equity source. The vesting period allows companies to retain employees and ensure they contribute to their growth over time.
What does an equity package entail in a startup?
An equity package in a startup generally includes various types of equity compensation, such as stock options, restricted stock units, or stock appreciation rights. This package incentivizes employees by aligning their interests with the company's and creating potential long-term value for both parties. The specific mix of equity types and allocation depends on the startup's size, stage, and overall compensation strategy.