Equity Compensation: Understanding the Different Types

Equity compensation has the power to boost a company’s long-term financial goals. This non-cash compensation gives employees partial ownership of the business. Both established businesses and startups offer equity compensation for numerous reasons, including freeing up cash flow, attracting high-quality talent, keeping the employees motivated and employed, and more.

4 Primary Types of Equity Compensation

Equity compensation comes in four basic types, listed below, each with pros and cons determining which will best suit your business and its employees.

  • Stock options
  • Restricted stock and restricted stock units
  • Stock appreciation rights
  • Phantom stock.

Stock Options

A stock option is a type of equity compensation that companies award their employees. Companies come up with unique stock option offers that allow their employees to buy a particular number of shares of a specific type at a price and for the period they set. Those companies spell out all the terms of the stock options for an employee in the employee stock options agreement.

Start-ups usually issue stock options to reward early employees when and if the company goes public. Fast-growing companies award them as an incentive for employees to work towards growing the company’s share value. Sometimes companies also issue stock options as an incentive for employees to stay with the company.

To understand how stock options work, one must familiarize oneself with the terminology:

  • Exercise refers to the purchase of stock under an option.
  • Employees may purchase stock at the exercise price (also called the strike price or grant price).
  • The term spread indicates the difference between the stock’s exercise price and its market value at the time of its exercise.
  • Option term refers to the time the employee can hold the option before it expires.
  • Vesting is the requirement that the employees should meet to exercise their right of the option. Vesting usually entails continued service for a specific length of time or meeting certain performance goals.

Companies grant their employees the option to buy a defined number of shares at a determined exercise price. Vesting happens after the employee meets specific criteria to qualify. Even though some firms set time-based vesting schedules, sometimes options may vest sooner if an employee meets performance goals. After the vesting date, the employee may exercise the option at the grant price before the expiration date.

For example, a company grants its employees the right to buy 5,000 shares at $20 per share. The options vest 25 percent per year over four years and have a term of 15 years. Even if the stock price increases, an employee will pay only $20 per share to buy the stock. The difference between the $20 grant price and the exercise price is the spread. If the stock goes to $45 after seven years and the employee exercises all options, the spread would be $25 per share.

The two different kinds of stock options listed below are subject to varying laws and tax consequences.

  • Incentive stock options (ISOs)
  • Non-qualified stock options (NSOs) or non-statutory stock options

In the case of an NSO after exercise, the employee must pay tax as ordinary income on the spread even if they have not sold the shares yet. The company deducts the corresponding amount. There is no legally required holding period for the shares, but the company may impose one. When the employee sells the shares, any subsequent profit or loss is taxable as capital gain or loss.

However, with an ISO, the employee may defer taxation until the date of sale and pay taxes on gain as capital gain and not as ordinary income tax. An option must meet certain conditions to qualify as an ISO:

  • The holding period of shares is one year after exercise and two years after grant.
  • Only $100,000 of stock options, measured by the options’ fair market value on the grant date, can first become exercisable in one calendar year. The portion of the ISO grant exceeding the limit is treated as NSO.
  • On grant, the exercise price must not be less than the market price of the company’s stock.
  • Only employees can qualify for ISOs, not consultants, suppliers, customers, etc.
  • The shareholders must approve a written plan to grant an option, the number of shares to be issued as ISOs, and the class of employees eligible to receive the opportunity. After the board of directors adopts the plan, options must be granted within ten years.
  • The exercise date should be within ten years of the grant.
  • If an employee holds over 10 percent of the company’s voting power of all outstanding stock at the time of grant, the ISO exercise price must be 110% of the stock’s market value on that date and may not have over five years of the term.

Restricted Stock

Investopedia defines restricted stock as “unregistered shares of ownership in a corporation that are issued to corporate affiliates, such as executives and directors.” Eligible employees get the right to purchase restricted stock plans at fair market value, a discount, or no cost; however, they do not receive possession–meaning they may not sell these shares–until pre-determined restrictions lapse. This restriction prevents employees from selling their shares to the company’s detriment.

Usually, the vesting restriction lapses at once or gradually after the employee completes three to five years of service. The company may impose other conditions apart from the time-based limits, such as achievements based on individual, departmental, or corporate goals.

Restricted stock units (RSUs) are like a phantom stock that the company settles in shares instead of cash.

Before vesting, companies may choose to give voting rights, dividends, or other shareholder benefits with restricted stock awards. Doing so with RSUs triggers punitive taxation upon the employee under deferred compensation tax rules.

On receiving restricted stock awards, employees can make the Section 83(b) election. Section 83(b) election is a form letter that the employee sends to the Internal Revenue Service asking to tax them on the shares of restricted stock on the grant date rather than on the vesting date. They get taxed as ordinary income tax on the bargain element of the award.

If the company grants the shares, the bargain element is the total value. If the employee pays some consideration for the shares, the bargain element is the difference between the fair market value at the time of the grant and the price the employee pays to get them.

If the employee pays for the shares in total, there is no tax. However, the difference between the filing price and the sale price of the shares is taxed as capital gain or loss. If the employee does not file an 83(b) election, they must pay the difference between the share price paid and fair market value on the vesting date as ordinary income tax and subsequent changes as capital gain or loss.

Phantom Stock and Stock Appreciation Rights

Both stock appreciation rights (SARs) and phantom stock are bonus plans that do not grant stock but give employees the right to receive an award based on the value of the company’s stock.

Stock appreciation rights provide cash or stock payment to the employee based on the increased value of a pre-determined number of shares over a specified period. On the other hand, phantom stock gives cash or stock bonus based on the value of a stated number of shares, paid out at the end of a specified period.

Unlike stock options, SARs do not have a specific settlement date, and employees may choose to exercise the SAR. While phantom stock offers dividend-equivalent payments, SARs do not.

The award value after the payout is taxed as ordinary income for the employee and is deductible to the employer. Sometimes companies apply conditions to phantom plans, which include award receipt on meeting specific performance targets. The phantom stock in such plans is called performance units.

The companies can give phantom stock and SARs to anyone. However, if a business gives them only to employees and pays upon the termination of employment, then they are considered retirement plans and are subject to federal retirement plan regulations.

Summing Up

Individual equity compensation plans can help businesses achieve their long-term financial goals and retain high-performing employees. However, it is critical to select a suitable method to meet its specific performance targets and satisfy employees and other parties. Consult your legal, tax, and accounting advisors or contact Value Scout professionals to utilize individual equity compensation plans to your benefit.

Author Summary

Makalyn Feaster

Makalyn Feaster

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