What is equity compensation?
Equity compensation is non‑cash pay that gives employees an ownership stake (or the right to acquire one) in the company. Common forms include stock options, restricted stock, restricted stock units (RSUs), and performance shares. Equity ties employee rewards to company performance and can help with recruitment and retention, but it also carries market, tax, and liquidity risk.
Key takeaways
– Equity compensation can amplify employee upside but is not guaranteed money — it depends on company performance and liquidity events.
– Different equity vehicles have materially different tax rules, timing of taxation, and employee rights (voting, dividends).
– Important features to check in any grant: type of award, number of shares/options, strike/exercise price, vesting schedule, expiration, post‑termination exercise window, change‑in‑control treatment, and tax/withholding rules.
– Employees should model value and tax scenarios, plan for liquidity and tax obligations, and consider professional advice for complex situations (e.g., ISOs, 83(b) elections).
Types of equity compensation (overview)
– Stock options — right to buy shares later at a fixed price (exercise/strike price). Commonly used in startups and tech firms.
– Non‑qualified stock options (NSOs/NSQs): taxed at exercise (bargain element treated as ordinary income subject to payroll/withholding); employer must report income.
– Incentive stock options (ISOs): available only to employees, can get favorable tax treatment (no regular tax at exercise if holding‑period rules are met) but may trigger alternative minimum tax (AMT) considerations.
– Restricted stock — actual shares granted but subject to vesting and potential forfeiture until vesting; taxed on vesting (unless a timely 83(b) election is made).
– Restricted stock units (RSUs) — promise to deliver shares (or cash) when vesting conditions are met; taxed as ordinary income when shares are delivered/settled.
– Performance shares/units — awarded only if pre‑specified performance goals are met (EPS targets, ROE, TSR vs. index, etc.); taxed when shares are delivered (similar to RSUs).
– Other forms: stock appreciation rights (SARs), phantom stock, employee stock purchase plans (ESPPs) — each has its own mechanics and tax rules.
Vesting and other plan mechanics
– Vesting schedule: determines when you earn the right to the award (commonly time‑based: e.g., 25% after 1 year “cliff,” then monthly/quarterly over 3 years). Performance or milestone vesting is also common.
– Exercise/expiration: options usually must be exercised before a stated expiration (often 7–10 years for grants; shorter windows after employment termination, e.g., 90 days).
– Transferability: most employee awards are nontransferable (except by will).
– Dilution and option pool: future financing can dilute your ownership percentage.
– Private company specifics: FMV set by 409A valuation; liquidity only on a sale/IPO or secondary market (rare).
Tax rules — practical summary (general principles)
(Always check current law and your jurisdiction; the examples below are U.S.-centric and illustrative.)
– NSOs
– Taxable event: exercise.
– Tax treatment: ordinary income equal to (FMV at exercise − exercise price); employer typically withholds and reports wages. Subsequent sale of shares produces capital gain/loss (basis = FMV at exercise).
– ISOs
– Taxable event for regular tax: generally none at exercise if holding periods are met.
– AMT: bargain element (FMV − strike) is an AMT preference item at exercise and can trigger AMT.
– Tax on sale: if holding requirements met (2 years from grant and 1 year from exercise), gain taxed as long‑term capital gain; if not (disqualifying disposition), part is taxed as ordinary income.
– RSUs
– Taxable event: vesting/delivery.
– Tax treatment: FMV on delivery taxed as ordinary income (with withholding); later sale triggers capital gain/loss (basis = FMV at delivery).
– Restricted stock (award of actual shares)
– Default: taxed at vesting as ordinary income based on FMV.
– 83(b) election: if filed within 30 days of grant, you can elect to be taxed on FMV at grant instead of at vesting; useful if FMV is low and you expect appreciation, but risky if the stock declines or you forfeit unvested shares.
– Performance shares: taxed when paid (generally like RSUs), based on value at payout.
Practical considerations and risks
– Liquidity: private company equity is illiquid until an exit or secondary sale; exercise costs and tax bills may arrive well before liquidity.
– Concentration risk: holding too much employer equity concentrates your financial risk; diversification is important.
– Tax cash needs: exercising or vesting can create tax liabilities; make a plan to fund taxes.
– Post‑employment exercise windows can force quick decisions (e.g., 90 days) — know the deadline.
– Plan documents: legal terms in your option grant, equity plan, and equity award agreement govern your rights — read carefully.
How to value and model equity grants (basic steps)
1. Determine number of shares/options and the company’s total outstanding shares (or option pool) to convert to ownership percentage.
2. For options, compute “spread” = (expected future price − strike price) and consider scenarios (downside, base case, upside).
3. For private companies, use latest 409A FMV for current valuation; understand that an eventual exit price may be very different.
4. For taxes, estimate ordinary income at exercise/vesting and potential capital gains at sale under different price outcomes.
5. Run a best/worst/likely scenario to estimate after‑tax proceeds and breakeven stock price.
Negotiating equity — what to ask for and negotiate
– Ask for or clarify: type of award (NSO, ISO, RSU), number of shares, strike price, vesting schedule, acceleration clauses (single or double trigger on change‑of‑control), post‑termination exercise window, repurchase rights on termination, dilution protections (rare), and treatment on termination/death/disability.
– Prefer clear acceleration language for change‑in‑control if you value liquidity or downside protection.
– For startups, negotiate total percent ownership rather than number of shares (shares are meaningless without a share count context).
– Consider asking for a cash salary increase if equity is being used to justify below‑market pay.
Practical steps for employees receiving equity (checklist)
1. Get your grant documents: obtain the award agreement, summary plan description, and any stock plan documents.
2. Identify the award type and key terms: number, type (NSO/ISO/RSU/restricted stock), strike price, grant date, vesting schedule, expiration, and post‑termination windows.
3. Confirm tax treatment and withholding: ask HR/payroll how taxes will be handled at vest/ exercise/settlement.
4. Model scenarios: estimate after‑tax value under conservative/expected/optimistic exit prices; factor in exercise costs and tax liabilities.
5. Plan for taxes/liquidity: if exercise or vesting triggers tax, decide how you will pay (savings, sale‑to‑cover, loan, or employer withholding if available).
6. Consider an 83(b) election (for restricted stock only): file within 30 days of grant if you want to accelerate tax to the grant date — weigh risks and consult tax counsel.
7. Understand ISO AMT exposure: if you have ISOs and large exercise, run an AMT projection with a tax advisor.
8. Track vesting and expiration dates: maintain a calendar reminder for vesting, exercise windows, and grant deadlines.
9. Diversify: avoid overconcentration in employer equity; consider rebalancing when shares become liquid.
10. Consult professionals: use a CPA/tax advisor for tax planning, and an attorney for reviewing unusual grant terms.
Simple example scenarios
– NSO exercise example:
– Grant: 1,000 NSOs, strike $2. FMV at exercise: $10.
– Ordinary income at exercise = (10 − 2) × 1,000 = $8,000 (subject to payroll tax and withholding).
– Basis for capital gains on later sale = $10 per share.
– RSU vesting example:
– Grant: 1,000 RSUs vesting when FMV = $10.
– Ordinary income at vesting = $10,000 (withholding applies); if you hold and later sell at $15, capital gain = ($15 − $10) × 1,000 = $5,000 (long‑ or short‑term depending on holding period).
When to get professional help
– If you have ISOs and are considering a large exercise (AMT exposure).
– If you’re thinking about an 83(b) election.
– If the grant terms (repurchase rights, acceleration, or tandem grants) are complex.
– When modeling large equity stakes tied to liquidity events.
Resources and authoritative references
– Investopedia — Equity Compensation overview: https://www.investopedia.com/terms/e/equity-compensation.asp
– Internal Revenue Service — Topic No. 427, Stock Options: https://www.irs.gov/taxtopics/tc427
– Internal Revenue Service — Equity (Stock)‑Based Compensation Audit Techniques Guide (August 2015): https://www.irs.gov/pub/irs-utl/equity-stock-compensation-atg.pdf
– Financial Industry Regulatory Authority (FINRA) — Employee Stock Awards: Five Questions Workers Should Ask: https://www.finra.org/investors/alerts/employee-stock-awards-five-questions-workers-should-ask
Bottom line
Equity compensation can deliver substantial upside and help align employees with company success, but it also brings tax complexity, timing and liquidity issues, and risk. Treat equity grants like a meaningful part of your total compensation package: read the documents, understand the tax and liquidity implications, model scenarios, plan for taxes and diversification, and get professional advice when the tax or legal consequences are material.