The Ultimate Guide to Equity Compensation

What drives companies to offer equity compensation? We’ve heard the speech … it fosters employee motivation and performance, it helps with employee retention, it’s an alignment of interests, it increases employee loyalty, etc. While all these are true, one big reason that gets less coverage is taxes. Equity compensation has a direct effect on employees’ financial planning, which is why it’s important that employees understand not only the tax implications but also how to exercise their stock and how to evaluate their options before accepting.

We are coming to a point in time when startup employees who received equity-based compensations as part of their payment package should be paying attention. For many, the option to sell some of their shares through the secondary market has become available; their vested shares are now monetarily beneficial. Plus, there’s a growing number of buyback programs instituted by companies at the moment. As equity compensation becomes more normalized, it’s important we all understand its benefits, potential downsides and implications.

Questions employees should be asking when accepting stock or stock options include: What type of equity am I receiving, and what are the tax implications? How do I know if I’m getting a fair price? What is the best way to split salary, equity and bonus? Our ultimate guide will hopefully clear things up.

Related: Your Privately Held Shares Jumped After an IPO. Now It’s Time to Consider Taxes.

Equity and taxes 101

We must understand the different types of equity that can be granted and their tax implications (bear in mind that there might be differences depending on the jurisdiction, and it’s always recommended to speak with a tax professional or financial advisor).

• Qualified Incentive Stock Options (ISOs): ISOs are the most attractive for tax purposes for employees. Employees do not recognize taxable income when they exercise ISOs, but they may be subject to alternative minimum tax (AMT) in certain cases.

• Non-Qualified Stock Options (NQSOs): NQSOs do not offer the same tax advantages as ISOs. When employees exercise NQSOs, they typically recognize ordinary income based on the difference between the fair market value of the stock and the exercise price.

• Restricted Stock Units (RSUs): RSUs are a form of equity compensation where employees receive units that represent the right to receive company stock in the future. RSUs generally have a vesting period, and once they vest, employees receive the underlying company shares. At the time of vesting, the fair market value of the stock received is typically considered taxable income.

The following are not as common but are always good to know about:

• Restricted stock awards: Restricted stock awards involve granting employees actual shares of company stock, subject to certain restrictions. These restrictions often include a vesting period or performance milestones that must be met.

• Employee Stock Purchase Plans (ESPPs): ESPPs allow employees to purchase company stock at a discounted price.

• Phantom stock: Phantom stock is a type of equity compensation where employees are granted units or cash bonuses that are tied to the company’s stock value.

• Employee Stock Ownership Plans (ESOPs): ESOPs are company-sponsored retirement plans that invest primarily in company stock.

ISOs and NQSOs are the most common types of equity plans, but each one has different exercise price limitations.

The exercise price, or the strike price, refers to the pre-established price at which an equity contract may be executed. This is set when the option price is created so it will have an effect throughout the life of the option. It’s important because it will determine the gains you make in the future.

• The exercise price of ISOs must be equal to or higher than the fair market value (FMV) of the stock on the grant date.

• The exercise price of NQSOs can be set at any value determined by the company, but it must be at least equal to the FMV of the stock on the grant date.

Related: What Founders Need to Know About Employee Equity

Pricing your stock

The real question is … how do I know I’m getting a fair price? There’s an infinite number of variables and combinations we could consider, but valuations are part art and part science. Some experts believe the three most important factors to consider are: current market conditions, the specific terms of your equity and the overall valuation of the company. Employees should know these things so that they’re equipped with the necessary information to negotiate.

• Stay informed about the market conditions and trends affecting the industry in which your company operates; economic climate, industry performance, investor sentiment, competitors, etc.

• Look for information on recent transactions involving similar companies or companies in your industry. Pricing benchmarks are usually very helpful.

• Evaluate the financial health and performance of your company; revenue growth, profitability, client growth and other key metrics that impact the value of your equity.

• Different types of equity compensation have different characteristics and potential values.

• Evaluate the growth prospects and potential future success of your company.

Overall, is it good to receive equity compensation?

Employees usually get very excited when offered equity compensation, but very few realize that this is not what’s best for everyone. How do you know how to find the best combination of salary, equity and bonuses? It all depends on your personal financial goals and financial plans. It has mostly to do with liquidity and timing. For example, your salary is more liquid than equity compensation. However, in the long term, equity can have a higher value than what you would have received salary-wise. Life circumstances usually dictate how much salary one is willing to sacrifice for more equity and vice versa. There’s not a single right size for all, but it’s good to know where you stand before you negotiate your compensation package.

Remember that compensation structures can vary significantly across industries, companies and roles. Assess your individual circumstances, tailor your compensation package to support your financial goals, and try to align your equity package with both your short-term and long-term objectives. After all, holding equity in a company can be an insignificant piece of paper or a goldmine for the future.

Related: Equity Compensation: Why Millennials Like It and How Entrepreneurs Can Use It