Equity Payout: Explained
EQUITY PAYOUTS
Equity compensation is a form of remuneration provided to employees through stock or stock options. It is a popular way for companies to incentivize and retain their employees while also aligning their interests with the company's—especially in the start-up world.
Equity comp can be confusing, so we’ll discuss the different forms of stock compensation and how companies use them to pay their employees.
STOCK OPTIONS
Stock options are one of the most common forms of equity compensation. They give employees the right to purchase a certain number of shares of the company’s stock at a set price, also known as the “strike price.” The employees can then sell the shares they purchase at the current fair market value price, potentially making a profit.
EXAMPLE:
A company grants the employee 10,000 options with a strike price of $10.00.
It would therefore cost the employee 10,000 x $10.00 per option or $100,000 to exercise their options.
After the employee has met their vesting period, the shares grow to a fair market value of $20.00 per share.
If the employee exercised and sold their options, they would pocket $10.00 per share of gains ($20.00 fair market value minus $10.00 cost to exercise).
If they exercised and sold all of their options, that would gain $100,000 ($10.00 per share profit x 10,000 options). What type of tax on the gain can depend on the type of option explained below.
INCENTIVE STOCK OPTIONS (ISOs)
Incentive Stock Options, or ISOs, are a type of equity compensation companies offer to their employees. ISOs are stock options that offer certain tax benefits and are typically granted to executives and other key employees.
Payout: ISOs
ISOs are paid out if the shares are exercised and subsequently sold. The employee can exercise the option by paying the exercise price, which is the price at which the stock can be purchased. The employee can choose to exercise the option and sell at the same time to realize the payout, if the shares are openly trading in the public or secondary market (private shares).
Employees may choose to exercise and hold the options for better tax treatment, but this not only means the cash payout is delayed, but you are investing your own money into exercising the shares + any taxes due at the time options are exercised.
Pro tip: While many search results will show that no regular income tax implications apply when exercising and holding ISO options, alternative minimum tax (AMT) can definitely apply, especially when the share price of your company stock is much higher than the exercise price.
Key Factors that Influence the Payment of ISOs
Exercise Price: The exercise price is the price at which the employee can purchase the stock. The exercise price is set at the time the option is granted, and it is typically equal to the fair market value of the stock at the time the option is granted.
Holding Period: The holding period is the period of time that the employee must hold the stock after exercise before they are eligible for long-term capital gains tax treatment. To qualify for long-term capital gains on ISO options, you must hold the shares for more than two years after the grant date of the options and more than one year after the shares are transferred to you upon exercise.
Stock Price: The stock price is another important factor that influences the payment of ISOs. If the stock price increases after the option is exercised, the employee may realize a gain on the stock. Conversely, if the stock price decreases after the option is exercised, the employee may realize a loss on the stock.
Taxation: The taxation of ISOs is a complex issue. The tax treatment of ISOs depends on several factors, including the exercise price, the holding period, and the stock price.
It is important for employees to consult with a tax professional to determine the tax implications of exercising their ISOs.
NON-QUALIFIED STOCK OPTIONS (NSOs)
Non-Qualified Stock Options, or NSOs, are another type of equity compensation offered by companies to their employees. NSOs differ from Incentive Stock Options (ISOs) in that they do not offer the same tax benefits as ISOs and are typically granted to a broader range of employees.
Payout: NSOs
Payouts for NSOs happen when the options are exercised and then sold. The tax treatment on NSOs are much easier to understand compared to ISOs. If you have unexercised NSO options, you can look at the gain of each option (current share price - strike price) as ordinary income that hasn't been taxed yet. When you do exercise the NSO, the gain will be added to your ordinary income, even if you don't sell the shares.
Key Factors that Influence the Payment of NSOs
Exercise Price: Exactly like ISOs, the exercise price is the price at which the employee can purchase the stock. The exercise price is set at the time the option is granted, and it is typically equal to the fair market value of the stock at the time the option is granted.
Stock Price: Very similar to ISOs
Taxation: Unlike ISOs, NSOs are taxed as ordinary income when the option is exercised. This means that the employee will owe federal and state income taxes on the difference between the exercise price and the fair market value of the stock at the time the option is exercised. In addition, the employee may owe social security and Medicare taxes on the taxable portion of the option exercise. Your company will likely sell some shares automatically for you to cover for taxes due, or require you to write them a check for the taxes if you do not wish to sell shares after exercising.
Vesting Schedule: The vesting schedule sets forth the conditions under which the employee will become entitled to exercise the option. For example, the employee may only be able to exercise the option if they remain employed with the company for a certain period of time.
RESTRICTED STOCK UNITS (RSUS)
Restricted Stock Units, also known as RSUs, are also a popular form of equity compensation offered by companies to their employees. Restricted stock awards are a promise to deliver a certain number of shares of stock to an employee at a future date, subject to certain conditions.
Payout: RSUs
RSUs are paid out when the restrictions on the units are lifted. The restrictions on RSUs are typically tied to the achievement of certain performance goals, the passage of time, or the attainment of a specific date. Once the restrictions are lifted, the employee is entitled to receive the underlying shares of stock.
The company may choose to pay the RSUs in cash or in stock, depending on the company's policies and the terms of the RSU grant.
If the company pays the RSUs in cash, the employee will receive an amount equal to the fair market value of the stock at the time the restrictions are lifted. If the company pays the RSUs in stock, the employee will receive the actual shares of stock.
Key Factors that Influence the Payment of RSUs
Vesting Period: The vesting period is the period of time during which the employee must meet certain conditions before the RSUs are paid out. The vesting period can range from a few months to several years, and it is determined by the company.
Company Performance: The performance of the company can also influence the payment of RSUs. If the company performs well, the stock price may increase, which could result in a larger payout when the RSUs are paid out. However, if the company performs poorly, the stock price may decrease, which could result in a smaller payout when the RSUs are paid out.
Market Conditions: Market conditions (such as economic trends and stock market performance) can also influence the payment of RSUs. If the stock market is performing well, the stock price may increase, which could result in a larger payout when the RSUs are paid out. Conversely, if the stock market is performing poorly, the stock price may decrease, which could result in a smaller payout when the RSUs are paid out.
Company Policies: The policies of the company can also influence the payment of RSUs. For example, the company may choose to pay the RSUs in cash or in stock, and it may have policies regarding the taxation of RSUs.
STOCK APPRECIATION RIGHTS
Stock appreciation rights, also known as SARs, are a type of equity compensation that allows employees to benefit from the appreciation of a company's stock without actually owning the stock.
SARs are often granted to employees as an incentive to improve their performance and drive the growth of the company.
Payout: SARs
The payment of SARs is based on the difference between the original strike price and the fair market value when you decide to exercise the SAR. For example, if an employee is granted SARs with an exercise price of $10 and the stock price reaches $20, the employee can either exercise their SARs to realize the $10 profit. The profit will be ordinary income, and usually paid out as cash. Unlike an option, you don't get to own the underlying share at $10 based on the strike price. However, some companies can give you the option to trade the $10 of cash payout for $10 worth of the company stock.
Key Factors that Influence the Payment of SARs
Stock Price: The stock price is the most important factor that influences the payment of SARs. If the stock price does not reach the exercise price, the employee will not be able to exercise their SARs or receive a cash payment.
Vesting Period: SARs typically have a vesting period, which is the period of time during which the employee must meet certain conditions before they can exercise their SARs. The vesting period can range from a few months to several years, and it is determined by the company.
Expiration Date: SARs also have an expiration date, which is the date after which the employee can no longer exercise their SARs. The expiration date is determined by the company, and it is typically several years from the date the SARs are granted.
Company Performance: The performance of the company can also influence the payment of SARs, similar to RSUs.
Final Thoughts
In today’s tech world, equity compensation is a very popular way for companies to incentivize and retain their employees. However, it can be difficult to navigate alone.
As always, it's suggested that you seek counsel with a financial planner or tax advisor to understand your personal financial goals and options better. These individuals can give you the tax advice you need to make an informed decision about your company shares.
If you are looking for help with your equity compensation options, we’d love to connect with you!
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