Introduction to Equity Compensation (aka Alphabet Soup)

If you’re new to the tech industry, the world of equity compensation might be unfamiliar with all the types of stock/stock options. It is, in fact, fairly complex and the terms and acronyms can seem like a ​​foreign language. To be honest, it often just takes time to get comfortable with the various concepts. In any case, I’d like to present an overview of the most common types of equity comp and how you can think about those.

I think it’s worth taking an even bigger step back and defining the word equity, as used in this context. Equity, at the most basic level, is a form of ownership. Stock is a type of equity and is used by many tech employers to make employment more compelling. When an employer grants equity to their employee, not only are they providing a better overall compensation package, they are typically hoping the employee will be more engaged and work harder as the individual stands to benefit from any increase in the value of the company.

Restricted Stock Units (RSUs)

If you work for a public tech company (and especially one of the FAANG companies) it’s very likely that you will be granted Restricted Stock Units (RSUs). RSUs are perhaps the easiest to deal with, both from a tax perspective and also from a decision-making point of view. As in, there are fewer decision points when it comes to RSUs. I wrote a more detailed explanation of them here.

With RSUs, your company will give you a grant of, say, 500 shares of their stock. But they don’t give them to you outright, they come with a vesting schedule.

It generally works something like this:

Beginning on 11/1/21, your shares will vest quarterly, 1/16 per quarter (or in this example ~31 shares per quarter). Or they might use something called cliff-vesting; the most common version being 4 year vesting with a 1-year cliff. In this example, 1/4 of the shares vest after 1 year and the rest vest as above, 1/16 per quarter for the remaining 3 years. In this case, that would be 125 vesting on 11/1/22 and then ~31 shares quarterly thereafter.

What exactly does vesting mean?

Essentially, it means the shares are now yours to do with as you choose. You can either sell them and use the cash for something else OR you may choose to hold on to them if you think the company’s future prospects are strong. It also means that the value of the shares on vest date is added to your taxable income for that year.

When you start a new job, you will typically be awarded an initial grant. In subsequent years, you may be offered a refresher grant, but the number of shares could be quite a bit less than the initial grant. This leads to a lot of “job hopping” as employees are not incentivized to stay after the initial grant has fully vested and their total comp declines.

There are multiple variations on how RSUs can work and the above examples are the most common. Recently I’ve seen companies shifting to an award that is based on dollar amount vs number of shares. Stripe recently shifted to this model (to the consternation of many employees) and now, instead of a specific number of shares vesting, you will be awarded a set dollar amount (say $5,000). Stripe will then calculate how many shares that is equivalent to on the date of vest. The downside with this structure is that there is less upside potential for the employee. If you hold the RSUs after they vest, they can always increase in value, but you have less opportunity to reap the benefits between grant and vest date.

Incentive Stock Options and Nonqualified Stock Options (ISOs and NSOs)

Another common type of equity compensation is stock options. Unlike RSUs, with stock options you’re not granted actual shares of stock, but rather the right to purchase stock at a certain price. Like RSUs, stock options are typically granted with a vesting schedule. There are two types of stock options- Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs). The primary difference between the two types is in how they’re treated from a tax perspective. 

Stock options are far more complicated than RSUs. Along with the decision about when to sell, they have an added decision-making component- with stock options you have to decide if/when to exercise (aka buy) your options AND when to sell. With RSUs, your only decision is when to sell.

How Stock Options Work

Your company might issue you stock options at a certain exercise price (i.e. the price you pay for the stock). For example, you might be issued stock options with an exercise price of $5/share. If the current value of company stock is $15/share, you can imagine these options being attractive! You can buy a share for $5 and then turn around and sell it for $15. Not a bad deal. This is where it gets tricky- the difference between the exercise price and the fair market value (also known as the “bargain element”) is taxed. In this example, the bargain element is $15 – $5, or $10. And the amount of tax you pay depends on the type of stock option and how long you hold the stock once you buy it.

Exercising ISOs

When you exercise ISOs, you trigger something called Alternative Minimum Tax (aka AMT). The mere idea of triggering AMT causes many people to panic, but not many people fully understand how AMT works (and I’m not going to explain it in detail for this article). But if you exercise and sell in the same calendar year, you simply pay ordinary income tax on the bargain element. Easy right? Not exactly.

If you plan to exercise and/or sell stock options, it is HIGHLY recommended that you work with a CPA who has knowledge in this area. The tax implications are significant and it’s very easy to make a mistake.

ESPP, PSUs and other forms of equity comp

RSUs, ISOs and NSOs are far and away the most common types of equity comp. There are others, however, and the Employee Stock Purchase Plan (ESPP) is one that has become increasingly popular.

Employee Stock Purchase Plan (ESPP)

The basic idea with an ESPP is that your employer allows you to buy the company stock at a discount, which you can then sell for a profit. The company withholds an amount from each paycheck for 6 month periods. At the end of each period, they take all of the accumulated contributions from your paycheck and purchase the stock for you. They’ll use either the price on the first day of the 6-month period or at the end of the 6-month period, whichever is lowest, and the discount gets calculated off the lower price. I wrote a detailed example of how this works here.

Restricted Stock Awards (RSAs)

Yet another type of equity compensation is Restricted Stock Awards (RSAs), which are NOT the same as RSUs. RSAs are generally issued by very early stage private companies. The shares are issued at grant and held in escrow until they vest. RSAs are eligible for something called an 83(b) election which allows you to pay tax on the “gain” (usually 0 or very close to it) up front, thereby enabling you to pay future gains at your capital gains tax rate.

Performance Share Units (PSUs)

You might be granted something called Performance Share Units (PSUs) which function much like RSUs but are tied to performance, not a traditional vesting schedule. The tax treatment of PSUs is the same as RSUs; in other words, the value of the shares on the date of vest is part of your taxable income.

Final thoughts

If you’re lucky enough to be granted some form of equity compensation, you’re likely recognizing some benefit from the value of your company’s stock. I’ve worked with clients who had 4 different types of equity compensation from their employer which gets incredibly complex. There are a host of considerations; from taxes to if/when to exercise and sell and what the proceeds will be used for. It’s incredibly useful to work with both a financial planner and a CPA who have expertise in this area.

The real fun begins when we start to discuss what opportunities you have available to you if your equity compensation ends up significantly changing your financial situation, as it very often does.