Equity has long been an important part of senior executive compensation at publicly traded companies. More recently, many of these companies have expanded the use of equity to lower levels of the organization, either as targeted incentives for key talent or as broad-based equity awards for all employees.
Equity compensation can be an important source of long-term wealth. However, it is not without risk. That is why it is important to understand how equity compensation works, how it is issued, and how to exercise these grants or options, along with the potential tax implications of doing so. We will focus on the three major forms of equity compensation–restricted stock units, stock options, and performance shares.
Restricted stock units (RSUs) are one of the most common forms of equity compensation and are generally designed to retain key talent. Employers grant an employee a specified number of shares in company stock in the form of RSUs on a specific grant date. However, employees are restricted from selling the underlying shares until a specified vesting date, at which time the employees own those shares outright. RSU vesting occurs using one of two vesting schedules–graded vesting and cliff vesting. These vesting schedules are also used in many 401(k) and other types of retirement plans.
Graded vesting allows a fixed percentage of the underlying shares to vest each year. If an employee receives 1,000 RSUs with graded vesting over four years, 250 RSUs (or 25%) would vest each year until the entire grant is vested at the end of the fourth year.
A cliff vesting schedule only allows the release of RSUs at the end of the full vesting period when those RSUs all vest at once. The “cliff,” or date when RSUs fully vest, can be triggered on a specific date or after the achievement of a specific goal (such as an initial public offering or a merger) to maximize their value as a talent retention tool.
It is important to note that RSUs are taxed as income as they vest, not when the employee sells the underlying shares. Even if the shareholder realizes a capital loss on those shares, they will still owe income tax based on the price at vesting. Once RSUs vest, the share price at the time of vesting becomes the cost basis for those shares. Any gain or loss realized by selling the shares after that date would be taxed as capital gains.
Stock options are contracts that give the employee the right to exercise or buy a pre-set amount of a company’s shares at a predetermined “strike price.”
Stock options follow a vesting schedule which keeps the shares locked up until a vesting date. For example, a company may grant an employee 5,000 stock options on a five-year vesting schedule with 1,000 shares (or 20%) vesting each year. The key difference between RSUs and stock options is that the employee awarded those stock options still has to buy the stock at the strike price in the contract. RSUs essentially gift the underlying shares to the employee.
As stock options vest, the recipient faces an important decision about whether to exercise those stock options. Of course, the ideal situation is that the options’ strike price is below the current market price for the company’s stock. However, there is no guarantee that this will be the case, and this is why stock options come with a certain amount of risk. Those who exercise their options only to see the share price decrease will lose any money spent to exercise the contract plus any taxes on the value of the exercised options. It is important to remember that stock options do not last forever. They expire after a certain date, usually ten years after vesting, or within a certain amount of time after an employee leaves the company.
Performance shares are designed to maximize the incentive element of equity compensation by tying these awards to the achievement of specific goals or milestones that benefit the company and its shareholders. Performance shares usually come in the form of restricted stock. Ultimately, performance shares can be clawed back for underperformance, awarded as planned for meeting baseline thresholds, or amplified in scale for superior outperformance.
For example, a company that wants executives to focus on certain company-wide performance targets (like meeting delivery quotas or increasing earnings per share) may offer performance shares that award each member of the management team 10,000 shares of company stock meeting those goals.
Equity compensation represents an important opportunity to accumulate wealth over time. However, maximizing their value while appreciating tax implications can be complex. By considering how these awards fit into your overall wealth management strategy, you can more confidently make decisions about how to manage these assets and maximize the beneficial impact they can have on your future.
If you have any questions about equity compensation, please contact a Blue Chip Partners financial advisor for guidance. We are here to help.
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