Don't Vest And Forget - Equity Compensation 101
Over the last several decades, employee equity has become a much larger part of employee compensation. Although not limited to tech companies, it has become especially popular among private and public tech companies to align employee incentives with the operational performance of the organization. The rationale is that if employees are compensated in company equity, their equity value will improve over time as employees are incentivized to maximize their company equity through greater work performance. Through equity compensation, employees have more "skin in the game," so to speak, concerning the company's performance.
A key feature of equity compensation to align employee incentives with the longer-term performance of the company is through what is called a vesting schedule. The vesting schedule is a pre-determined timeline for an employee to receive the benefit of the initially granted equity. A typical vesting schedule is equally over four years, with a one-year cliff and quarterly (or monthly) after that. So, for example, if an employee is granted 10,000 options in their company on this kind of vesting schedule, they will vest into 2,500 shares on their first anniversary and then 625 options every quarter afterward until they reach the full 10k on their fourth work anniversary.
Before diving into the various forms of employee equity compensation, it is crucial to understand a stock option. A stock option is a right, not the obligation, to purchase a stock at a pre-determined price. So, simply having a stock option is not equity (stock) ownership in and of itself. It is the right to purchase stock and become an equity owner at a specific price point. That price is known as the strike (or exercise) price - keep this definition in mind as we dive deeper into equity compensation.
There are various forms of employee equity compensation that usually relate to the stage of the business. Incentive Stock Options (ISOs) are typically granted at an earlier stage of a company while still a private, venture-backed company. Then there are Non-Qualified Stock Options (NSOs or NQSOs) that are typically issued by later-stage private companies and publicly traded companies. After that, there are Restricted Stock Units (RSUs), and it's closely related Performance Stock Units (PSUs). Historically, these have been issued by publically traded companies, though over the last ten years or so have become more popular among highly valued private companies - typically among the "Unicorn" status of private valuations north of $1B.
The Incentive Stock Option
Starting from the top, Incentive Stock Options are a form of stock option with a special tax treatment under the tax code and are typically the most complex from a tax perspective. When granted ISOs, the exercise price will ($1) equal to the current fair market value (FMV) of the stock ($1). So from that perspective, the stock option will have no inherent profit or intrinsic value. However, to continue the previous vesting example, let's say after the employee's one-year cliff, they wish to exercise the 2,500 ISOs they have been vested. Now let's say the FMV has appreciated to $2/sh. If the employee exercises the options, the profit ($2500*2-1=$2,500) will not be taxable under ordinary income taxes. However, that profit will be taxable under the Alternative Minimum Taxes (AMT). It will depend on the employee's individual tax situation to determine if that will ultimately cause the employee to owe AMT that year. I recommend working with a wealth and tax advisor to help understand how exercising ISOs will impact your income taxes, so please reach out if we can be of help here.
From there, with the options exercised, the employee now owns the stock in the company. If the employee were to sell the stock within a year, that would be a disqualifying disposition, and any profit above the $1/sh strike price would be taxable as short-term capital gains. If the employee holds the stock for greater than a year from exercise and greater than two years from the grant date, then that would be a qualifying disposition and taxed at long-term capital gains above the $1/sh strike price.
To reiterate, ISOs are typically the most complex form of equity compensation, and the description here is hypothetical and simplistic. So if you have ISOs and are wondering what you should do about them, I recommend seeking the professional advice of a qualified planner who understands these options' intricacies and how they'd impact your financial position. Please reach out if we can be of help here.
The Non-Qualified Stock Option
Next up, we have NSOs - which are, again, the right to purchase stock at a given price. Also, like ISOs, NSOs typically are granted equal to the FMV of the stock, so there is no inherent profit in the option. However, a company can issue NSOs less than the current FMV if they want. Regarding taxation, upon exercise, any inherent gain in the option at the time of exercise is immediately taxable under the ordinary income tax. Continuing with the example, that would be $2,500 of ordinary income, which is taxed just like if you earned it in salary, bonus, or commission. Typically there will be tax withholding at the time of exercise to help cover these taxes, though it is quite common for there to have needed to be more withheld to cover all of the taxes.
After exercise, if the employee were to sell the stock within less than a year, any additional gain of the stock price from the FMV at the time of exercise would be a short-term capital gain, or any decline would be a short-term capital loss. If the employee holds the stock for greater than a year, the profit or loss above or below the FMV at the time of exercise will result in long-term capital gains or losses.
The Restricted Stock Unit
Moving on to RSUs, and PSUs, these are the most simple of all the forms of equity compensation. RSUs are distributed to the employee on the pre-determined vesting schedule, similar to options. But unlike stock options, with RSUs, employees are actually given stock by the company, and the employee does not have to purchase them. So continuing on the previous example, on the one-year work anniversary, the employee would vest into 2,500 shares of the company stock. However, RSUs (and PSUs) are taxed immediately upon vesting at the FMV of the stock on the day it vests under the ordinary income tax rates.
So continuing the example, at the time of vesting, the stock is now worth $2/sh, making the 2,500 RSUs worth $5,000. This $5,000 is taxable to the employee just like a cash bonus or paycheck for which there is typically Federal and State tax withholding on the day of the vest. So in actuality, while the employee vested into 2500 RSUs, they typically receive less than that because shares are withheld to pay for taxes. However, for many high-earning professionals, the withholding rates usually need to be higher to cover the true tax liability from vesting into the stock. So it is wise to work with a qualified advisor to help determine how much of the vested stock should be allocated for additional taxes.
Once the RSUs are vested, they are shares that the employee owns outright, and that starts the capital gains tax clock with the new tax basis being the FMV of the stock on the day of the vest. If the RSUs are sold at a gain/loss from that FMV within a year, then short-term capital gains/losses will need to be accounted for in taxes. If the RSUs are sold at a gain/loss from that FMV after a year, then long-term capital gains/losses will need to be accounted for in taxes.
To quickly touch on PSUs, these are treated precisely the same as RSUs from a taxation point of view. However, typically PSUs are granted/issued based on hitting specific performance metrics that the company or employee hits in a given timeframe. Further, they typically are either immediately vested or vest over a much shorter timeframe than the standard four-year schedule. PSUs are most akin to performance cash bonuses but paid in stock instead of cash.
In conclusion, ISOs, NSOs, RSUs, and PSUs are all forms of employee equity compensation that each have unique wealth planning impacts and considerations. Taken individually, they can be complex enough to the point of needing professional guidance. However, it is becoming more common for tech professionals to receive grants of multiple forms of equity compensation over their employment tenure. In all cases, it is recommended not to vest and forget by intentionally understanding and analyzing all equity grants and implementing a full-vesting-cycle strategy integrated with an overall wealth plan.