Stock compensation is a method companies use to reward their workforce by providing stock options or other equity-based incentives. Employees with stock options need to understand if their stocks are vested and how they can retain their value even if they leave the company. Tax consequences are tied to the fair market value (FMV) of the stock, and any tax due must be paid in cash, even if the compensation was received in the form of equity.
Key Takeaways
- Stock compensation is a beneficial method that allows companies to reward employees using stock or stock options instead of cash.
- Typically, stock compensation involves a vesting period before employees can collect and sell the stock.
- Vesting periods commonly stretch from three to four years, often starting after the employee’s first eligible work anniversary.
- There are two primary types of stock compensation: non-qualified stock options (NSOs) and incentive stock options (ISOs).
- Some companies provide performance shares to executives and managers based on achieving certain performance metrics like earnings per share (EPS) or return on equity (ROE).
The Mechanism Behind Stock Compensation
Stock compensation is frequently utilized by startup companies, due to limited cash on hand for competitive salaries. This strategy allows executives and staff to “grow with the company” and enjoy future profits. Compliance with various regulations is crucial, involving fiduciary duties, tax implications, deductibility, registration issues, and expense charges.
When it comes to vesting, companies offer employees the chance to purchase predetermined shares at a set price. Vesting could happen all at once on a specific date or gradually on a monthly, quarterly, or annual basis. This period usually starts three to four years in but often has an initial kick-off after the first year of employee eligibility. Upon vesting, employees gain the right to buy stocks before their option expires.
Example of Stock Compensation
Imagine an employee has the right to purchase 2,000 shares at $20 each, where 30% of these options vest annually over three years with a five-year term. Regardless of the stock price in those five years, the employee pays $20 per share.
Various Types of Stock Compensation
Different types of stock compensation offer varied benefits and conditions:
- Non-Qualified Stock Options (NSOs)
- Incentive Stock Options (ISOs)
ISOs are exclusive to employees, offering special tax benefits, whereas NSOs are broader. NSOs require paying income tax on the price difference between the grant price and the exercised price. Other types include:
- Stock Appreciation Rights (SARs) which can be converted into cash or shares based on a set value.
- Phantom Stock pays a cash bonus equalling share value at a later date.
- Employee Stock Purchase Plans (ESPPs) allow employees to buy company shares at a discounted rate.
Restricted Stock
Employees can receive shares as purchase or gifts after certain service years and performance goals through Restricted Stock or Restricted Stock Units (RSUs). Restricted stock becomes available after fulfilling vesting periods that can be linear or lump-sum over varied timelines. RSUs have promise of future payment of shares based on vesting schedules and they don’t provide shareholder rights until shares are officially earned and given.
Performance Shares
These are awarded to executives and managers if particular metrics like EPS targets, ROE, or company stock returns related to indices are achieved. These targets often span over several years.
How to Exercise Stock Options
Stock options can be exercised in several ways such as paying cash, trading shares already possessed, partnering with a broker for a same-day sale, or executing a sell-to-cover transaction. Companies typically prefer one or two of these methods. It’s important for employees to note that private companies usually limit the sale of acquired shares until they go public or are sold.
Through effectively understanding and leveraging stock compensation, employees and companies can mutually benefit, thus paving the way towards a successful financial future.
Related Terms: fair market value (FMV), equity compensation, stock options, vesting, incentive stock options (ISOs), non-qualified stock options (NSOs), performance shares, restricted stock units (RSUs).
References
- Internal Revenue Service. “Publication 525: Taxable and Nontaxable Income”.
- Fidelity. “Incentive Stock Options (ISOs)”.
