The various ways equity can be granted to employees as compensation are notoriously complex. Please don’t take it lightly when I say it takes some know-how to develop a pragmatic approach to managing equity compensation. For starters, there are a few common types of employee equity compensation plans: stock options, restricted stock and restricted stock units (RSUs), and employee stock purchase plans. Each type of equity compensation vehicle has unique characteristics. With this in mind, it’s essential to identify your equity compensation type so you can understand the potential challenges and take advantage of the benefits.
You must know the rules before you play the game. Understanding the structure of equity compensation does not guarantee you a fortune. Still, it will help you make better decisions for your personal life, and avoid some common and costly mistakes. So let’s jump right into it.
Employee Stock Purchase Plans (ESPPs)
Some people may argue that ESPPs are a more attractive benefit than stock options. It’s me. I’m some people. I’ll be honest, of all the types of employee equity compensation, ESPPs are my favorite. Why? Because it allows you to purchase company stock easily and on favorable terms. Particularly, ESPPs enables employees to buy company stock at a discount from the market price. The most significant discount the IRS allows is 15%. That doesn’t beat Saks 5th Ave discount I had back in the day, but hey, it’s definitely something worth talking about.
Anyway, so you can better understand the features of ESPPs, let’s dive into their life cycle:
- Offering period – the period during which your rights to purchase company stock are available. You will need to establish your after-tax payroll contributions to participate.
- Offering date – the first day of the offering period, and usually follows the enrollment deadline. For tax purposes, this is the date of the grant. It will determine how long you held onto the stock before selling. It’s also called your holding period.
- Purchase period – generally, when an offering period is longer than six months, there will be interim purchase periods within an offering period. For example, a 12 month offering period can have two 6 month purchase periods.
- Purchase date – your accumulated payroll contributions will buy shares of company stock at the discount price at the end of the purchase period.
- Lookback feature – allows flexibility in the purchase price.
How It Works
Let’s say you have $1,000 deducted from your paychecks to invest at the end of every purchase period. The price at the beginning of the period was $10 and increased to $15 by the purchase date. Because of the lookback feature, your purchase price will be the 15% discount from the market price at either the beginning or the end of the purchase period — whichever is less. In theory, employees could buy and sell company stock at a built-in profit of at least 17.6%. Talk about easy money 🤑
The icing on the cake: If you hold on to your shares for two years from the grant date and one year purchase date before selling, it is known as a qualifying disposition, and a portion of your gains will be taxed at the favorable long-term capital gains rate.
Restricted Stock and Restricted Stock Units (RSUs)
Restricted and RSUs represent minimal market risks, relatively speaking. Unlike stock options, which can lose all practical value, restricted stock and RSUs are always worth something, even if the stock price drops dramatically. The stock is “restricted” because it is usually subject to a vesting schedule, which is based on length of employment or performance goals. While the vesting rules are similar for RSUs, no actual stock is granted. RSUs are simply a promise to issue a specific number of shares when employees meet vesting requirements.
With restricted stock and RSUs, employees are taxed at the time the shares vest and become yours wholly. The market value of your shares will be taxable income. Subsequently, your company will likely withhold taxes at vesting. They generally elect to do so by holding onto some shares to cover the taxes. Some companies also have the flexibility to withhold taxes using salary deductions or payment by check.
Section 83(b) Election
Alternatively, the 83(b) election permits employees to pay taxes at grant, rather than at vesting. This is especially beneficial if you have good reason to believe that the stock price will be significantly higher on the vesting date than it is on the grant date. If the price at vesting is higher, the taxes you pay on the lower grant price through the 83(b) election will be less than the taxes you would have paid at vesting.
One caveat: The 83(b) election can only be used with restricted stock, not RSUs.
Employee Stock Options
A popular type of employee equity compensation plans among Silicon Valley and startups is stock options. Fundamentally, a stock option is a contractual agreement that gives employees the right to purchase a stated number of shares of the company at a fixed price. Typically, it’s required for employees to work at the company for a specified length of time before you are allowed to exercise your right to buy any of the stock options. This is known as the vesting period. Any employee who terminates employment will forfeit all unvested stock options.
Beware: employee stock options will expire if they are not exercised.
Employees usually have ten years from the grant date to exercise stock options, if still employed with the company. Since the purchase price is often the company’s stock price on the grant date, stock options become valuable only if the stock price increases. Ultimately, this creates a discount between the market price and your lower exercise or purchase price. Nonetheless, any value in stock options is entirely theoretical until you exercise them. This is what people mean when they say you’re only rich on paper.
And this folks, is your introduction to the most common types of employee equity compensation plans.
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