Equity compensation packages are becoming more and more popular. In today’s competitive job market, employers are going above and beyond to attract and retain top talent. Companies are increasingly offering equity compensation to sweeten the deal.
Whether you’re starting your career at a fast-growing startup or joining a well-established corporation, equity compensation can be a game-changer, providing a unique opportunity to share in the company’s success.
If your offer includes some form of equity compensation package, it’s important to know how these offerings work, how they can fit into your overall investment portfolio, and how a financial advisor can help you navigate their complexities.
Why Companies Offer Equity Compensation
Equity compensation is a form of non-cash payment that offers an employee part ownership in the company. This allows a business to make a competitive job offer to a candidate while minimizing their cash outlay. Sometimes it’s designed to offset a below-market salary; other times it’s added on top of an already competitive base salary.
Companies of all types, especially in major metro markets, are offering equity compensation to lure the talent they need to achieve their goals.
- Startups that need to preserve capital to fund their operations often use it to boost the total package without tying up cash in large salaries.
- Businesses with ambitions to go public may hold out the lure of a surging stock price once an initial public offering (IPO) occurs.
- Even large public companies with high pay scales offer equity compensation, especially in highly competitive fields like technology.
The Most Common Forms of Equity Compensation
While there are various ways a company can provide employees with equity in the business, the most common types are stock options, restricted stock units (RSUs) and employee stock purchase plans (ESPPs).
Stock options allow you to buy shares of your company’s stock at a price that is set when the stock option is offered (the “strike price”). You can’t exercise the option to buy those shares until they vest, and typically the options vest over time to encourage you to stay. There are two types—incentive stock options (ISOs) and nonqualified stock options (NSOs)—and each is treated differently for tax purposes as we discuss below.
Since stock options are common in early-stage companies, when the organization’s value is relatively low, the strike price tends to be low too—increasing the odds that the stock’s fair market value will rise over time and provide a nice gain.
Let’s say you have the option to buy 10,000 shares of company stock at a strike price of $7 per share with a five-year vesting period. At the end of year 1, the stock is selling at $11 per share. If you exercise the 2,000 shares that have vested, you would acquire $22,000 worth of stock for $14,000. If the value of the stock never exceeds the strike price, you’re not obligated to exercise the stock—hence the term “options.”
NSOs are taxed at ordinary income tax rates in the year they are exercised. The tax applies to the “Bargain Element” which is the difference between the strike price and the market value of the stock at the time of exercise. ISOs on the other hand, are not subject to ordinary tax rates when exercised but could make you subject to Alternative Minimum Tax (AMT). The rules around AMT are very complex so before you exercise any ISOs, make sure to talk to your CPA about potential AMT consequences.
Finally, if you end up selling the stock, the taxation will depend on the amount of time you held the stock, the price of the stock at sale, and whether the option was an ISO or NSO.
Restricted stock units (RSUs) are common in more mature companies, typically after they’ve gone public. Unlike stock options, which offer you the choice to buy shares, RSUs are given to you directly. Like stock options, RSUs vest over time to encourage you to stay on board.
Let’s say your package includes 10,000 RSUs that vest over five years, and at the end of year 1 you’re eligible to receive 2,000 shares. The day you receive them, the fair market value is $10 per share. You now own $20,000 of your company’s stock—without laying out any cash. You would be taxed on that $20,000 at ordinary income rates in the year you receive the stock. If the stock goes up from the time you receive it and you decide to sell, the investment gain would be taxed at capital gains rates.
Employee Stock Purchase Plans (ESPPs) allow you to buy your company’s stock at a discount, which is often as high as 15 percent. To participate in an ESPP you need to enroll in the plan and make contributions through payroll deductions. Then on certain purchase dates that the company specifies, you can use the accumulated funds to buy the stock at the discounted price. The contributions are “after-tax,” and the purchase price of the stock then becomes the stock’s cost basis. Any gain in excess of the cost basis is taxed at capital gains rate if you decide to sell the stock.
How Equity Compensation Affects Your Financial Picture
If you receive equity compensation as part of your total package, it’s important to understand how these assets fit into your overall financial picture. There are three factors to consider:
- Asset Diversification. Depending on how much equity compensation you receive and the total value of your other assets, you could have a large concentration of assets in your employer. The greater your exposure to a single company, the greater your investment risk. Even if you perceive a high potential reward down the road, it’s prudent not to concentrate too large a percentage of your assets in your company’s stock. While the right allocation varies by individual, based on factors like your risk tolerance and how close you are to retirement, Team Hewins advisors typically recommend keeping no more than 10 percent of your assets tied up in your company’s equity.
- Tax Implications. The taxation on equity compensation depends on the type of offering. Taxes should be one of the biggest considerations when putting together a strategy for your equity compensation. Selling stock with the highest cost basis (i.e., the highest cost at the time you received or exercised them) is one way to help minimize your tax liability. If you exercise a certain amount of ISOs in one year, they may become subject to Alternative Minimum Tax (AMT). The point it is important to understand the full tax implications before you exercise your options and/or sell your shares. A team of a financial planner and CPA can outline the tax consequences for you while factoring in your unique situation and goals into your equity compensation planning.
- Liquidity Needs. If you need access to your funds to cover unexpected expenses or a large, planned purchase, you might want to free up liquidity by exercising and selling stock options or selling RSUs. It’s best to make that decision as part of your overall financial plan, based on your short- and long-term goals. For example, if you’d like to purchase a home within the next two years, you could consider exercising vested stock options or selling RSUs to help cover the down payment.
How A Financial Planner Can Help
A CERTIFIED FINANCIAL PLANNER® professional can help ensure your total portfolio—including equity compensation—is allocated in the best way to optimize your returns while minimizing your risk. An advisor who is experienced with equity compensation packages can:
- Evaluate how much of your assets are concentrated in your employer
- Determine whether it would be advantageous to diversify your assets more broadly
- Recommend tax-efficient strategies for diversifying your investments, including your equity compensation
- Help you understand the tax implications of receiving RSUs, exercising stock options, or selling company stock of any kind
The fee-only advisors at Team Hewins can review your equity compensation package and help you make the most of it within the context of your total portfolio. Contact Team Hewins to schedule a financial planning consultation today!
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