Here’s the main benefit of receiving employee equity compensation: It has the potential to bolster your long-term financial goals.
You’ll be reading that word a lot throughout this article. We’ll discuss why.
Given the rise in popularity of equity as a form of employee compensation – and thus, as a potential portion of your wealth – it’s important to know the basics of popular forms of equity compensation.
The Personal Capital Guide to Employee Equity Compensation gives you an in-depth look into this form of compensation, plus how it fits into your tax strategy, overall net worth, and long-term financial plans.
Equity compensation can be complex. But with the right knowledge and a clear strategy in place, you may be able to leverage your equity compensation within a comprehensive financial plan to meet your goals even sooner.
Let’s dig in.
What Is Employee Equity Compensation?
Employee equity compensation is a form of non-cash compensation that gives you partial ownership in your company.
Both startups and established companies offer equity compensation for myriad reasons. One of the more common purposes is allowing a company to free up cash flow by providing an equity offer as a form of compensation instead of cash. Another driver is attracting high-quality talent — and then keeping those people motivated to both achieve performance goals and remain employed with the company.
Katie Z., a Personal Capital client, received equity compensation from a startup she helped build from the ground up. She now says her biggest financial accomplishment was when her company was acquired: “At startups, work becomes personal. It was almost like the cousins’ table at Thanksgiving; we were all in this together. The acquisition gave me a new type of asset that I needed to figure out.”
Read More: How Katie Managed the Windfall From her Company’s Acquisition
Katie is a client of Personal Capital Advisors Corporation, and she was not paid for this testimonial.
Main Types Of Equity Compensation
There are generally three types of equity compensation awarded to employees:
Employee stock purchase plans (ESPPs)
Each type of compensation has unique characteristics, so it’s important to identify your type of equity compensation so you can understand its benefits and potential challenges.
Employees have the right, but not the obligation, to purchase shares of company stock at a predetermined strike price
If the company’s stock price rises, employees are able to purchase shares at a discount with their options
Employee stock purchase plans (ESPP)
Employees can purchase shares of company stock on a set schedule through the use of payroll deduction
Employees are able to purchase company stock at a discounted price, often with tax advantages
Employees receive restricted stock units (RSUs) as a form of compensation
Restricted shares serve as an additional form of compensation for employees, and allow companies to retain key employees
Read More: Get Your Guide & Understanding Your Options
Katie felt overwhelmed when she was finally able to access her equity. She already used the free and secure Personal Capital Dashboard to manage her finances. But when her company was acquired, she realized she needed a plan to best take advantage of her equity.
She took up the offer for an advisor’s complimentary analysis of her financial life. In that first series of consultations, Katie said she felt more at ease. “Someone sat down and really took the time to get to know where I was,” she said. “He was able to give me different ways to think about my financial life.”
With stock options, employees have the right — but not the obligation — to purchase company stock at a predetermined exercise price. Types of stock compensation options generally can be categorized as either Incentive Stock Options (ISOs) or Nonstatutory Stock Options (NSOs), which are sometimes also known as Non-Qualified Stock Options (NQOs).
The biggest difference between these two types is their tax treatment. NSOs are taxed as ordinary income when the employee exercises them. If the shares are held more than one year after exercise, they can be sold at preferential long-term capital gains rates. ISOs are a bit more complex but can have potential tax benefits depending on when they’re exercised and how long the shares are held before sale.
Exercising ISOs may or may not cause the alternative minimum tax to apply, but if the shares are held more than two years after grant and more than one year after exercise, they can be sold at long-term capital gains rates which are typically lower than ordinary income rates.
Employee Stock Purchase Plans (ESPPs)
In an employee stock purchase plan (ESPP), employees are able to buy company stock, usually at a discount. Employees contribute to the ESPP via payroll deductions. On certain dates, the company will use the funds in the ESPP to purchase shares for the employees, often at a discount of 5-15%.
If the shares are held more than two years after grant and more than one year after purchase, they can be sold at long-term capital gains rates. That can be a nice tax benefit, but in some cases, it can also make sense to just sell shares as soon as possible and capture a guaranteed discount.
Restricted shares (in the context of equity compensation) are usually structured as either Restricted Stock Units (RSUs) or Restricted Stock Awards (RSAs). Unlike other types of equity compensation, employees don’t have to buy them – they simply receive the shares as compensation.
Companies usually grant RSUs on a vesting schedule that’s tied to either a particular amount of time with the company or certain performance milestones. An employee doesn’t get any tangible value from the shares until they’re vested. When RSUs vest, their value is considered ordinary income.
What’s the Value of Employee Equity?
When considering the true value of employee equity, you are often in a speculative position.
Sure, you have the possibility of coming into a windfall like Katie. But keep in mind that you’re also placing a bet on the same company that also signs your paycheck.
The biggest risk comes if most of your net worth is tied up in your equity.
Rather than let company stock dominate your portfolio, part of managing your wealth is figuring out how (and when) to:
Sell down some of your shares in a tax-efficient manner
Build a diversified portfolio appropriate for your risk tolerance and your financial goals
It’s important to understand your awards, vesting schedule, potential tax consequences, and concentration risk within your overall allocation. The more information you’re armed with, the better you know what your equity compensation could ultimately be worth — potentially.
Next Steps for You
To get a handle on your equity, download Personal Capital’s Guide to Employee Equity Compensation. This free resource provides you with:
Key questions to ask when offered equity in a company
Strategy on tax optimization
Tips on exercising
When you get the guide, you also gain access to Personal Capital’s free, award-winning financial Dashboard — the same tools that Katie used to manage her investments and plan for her big financial goals, like buying her first home.
“The only reason I felt comfortable and confident knowing that I could buy a house was because I could see my assets in one place,” she said. “I was able to see how a down payment would impact my overall financial situation.”
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