Have a Plan for Equity Compensation
Over the last couple months I’ve had several conversations regarding the different experiences people have had involving employee equity compensation. This is an interesting topic and one people often have questions about so I thought it would be worthwhile to offer up some basic advice.
First, let’s quickly summarize some of the most common types of equity compensation offered by employers today.
Stock Options (NSOs and ISOs)
Until about 10 years ago when a tax law change required companies to expense them, stock options were by far the most popular form of equity compensation.
An employee with stock options will have the “option” to purchase shares of company stock at an agreed upon price in the future. Employee stock options fall into two separate categories, non-qualified options (NSOs) and incentive stock options (ISOs). The major difference between the two types is in their tax treatment. While NSOs are always treated as regular income, ISO’s, depending on the exercise date, can be treated as either regular income or as long-term capital gains. Because options are leveraged assets, they have the potential to gain a great deal of value. That potential doesn’t come without risk, however. It is possible for stock options to lose all of their value if the market price does not appreciate beyond the strike price by the vesting date.
Restricted Stock (RSUs & RSAs)
With both restricted stock units and awards, an employee is granted full value shares of company stock that will vest over a predetermined period of time. Unlike options, restricted stock can never be “underwater” at the time of vesting (unless the stock price drops to $0 of course).
There are a couple major differences between RSUs and RSAs worth noting. The IRS considers RSAs taxable transfers of property which are subject to ordinary income tax on their vesting date. The holder of an RSA can make an 83(b) election that would accelerate the tax liability of the equity position by paying before it vests. The risk here being that if the equity decreases in value over the course of the vesting schedule, the employee will have ended up paying more in taxes than if they had not made the election.
RSUs are not grants of outstanding shares, but obligations by a company to provide shares to the holders at a predetermined time in the future. For this reason, RSUs are not considered a transfer of property and the holders are taxed when the shares are delivered. Read more on the differences between RSUs and RSAs here.
Performance Shares (PSUs and PSAs)
Performance shares are increasing in popularity and are very similar to restricted stock. While the vesting schedule for restricted stock is time-based, performance shares, as the name implies, typically vest based on the meeting of certain performance goals. Unlike RSAs and RSUs, the structure and details of these grants may vary greatly from company to company. The tax implications to the employee for these awards is similar to RSAs and RSUs.
These explanations are very basic but I’ve provided some links to further reading at the bottom of this post. Managing company equity can be very complicated and you should always consult your financial planner or tax professional before making any major decisions. For those who hold equity, here is some general advice that will be helpful when planning for your future.
Don’t Count Your Chickens Before They Hatch
I once heard somebody tell their employees to treat unvested company equity as “found money.” I think that is a pretty good idea. The future is a crazy place and you never know what is going to happen. Don’t let the daily stock prices captivate you. We’ve all heard the late 90s stories of entire companies glued TV screens watching their stock prices meteorically rise on CNBC. That didn’t end well. Keep working hard and focus on the reasons that got you equity in the first place.
Beware of Overexposure
Be careful not to wind up with too much of your financial well-being tied to one company. I don’t recommend that anybody have more than 5% of their investment capital tied up in any single company. It’s important to recognize that as an employee, a big part of your financial health is already dependent on the company’s success. You are likely relying on this company for both an income and benefits. Should something unanticipated happen and the company’s performance suffer, you certainly don’t want to be at risk of losing your job AND a significant portion of your savings. Manage the risk and diversify your investments.
Have a Plan
Unfortunately, most of the time it is very difficult to hedge your risk when holding company equity. Wealthfront had a great article on this last year and I 100% agree with their conclusion.
In theory hedging your hard-earned stock options and RSUs can make a lot of sense. Unfortunately there simply aren’t any really good options to do so which might just make selling a chunk of your stock upfront and the remainder over time a much better strategy.
Having a plan to exit and reallocate your company equity into more diversified assets keeps you honest and unemotional. Sure, many people want to hang on and hope for riches but I try to steer my clients down the safest path possible. The more prepared you are, the lower the risk and the more opportunities there will be to shoot for the stars in the future.
Further Reading via Fidelity