There are many ways a company can compensate its employees for the work they put forward in advancing the company’s goals. While the most common is cash payments, there are several methods of stock-based compensation that encourage an employee’s longevity with the company while also allowing the employee to participate in growth in the company’s value. This article will review the main types of stock-based compensation and some ways to think about factoring that compensation into an overall financial plan.
A frequently-used type of compensation is the restricted stock unit (RSU). Companies can choose to offer this type of award as compensation in addition to more traditional cash payments such as wages, salaries, and cash bonuses. When an employee receives an award (the grant date), the number of shares issued as well as the vesting schedule for the employee to receive those shares is laid out in advance. Typically, the employee needs to stay with the company for a certain period of time beyond the grant date to receive any benefit. Schedules for vesting can vary widely by company but one example of a common vesting schedule is to receive 25% of the total award after the first, second, third, and fourth years following the grant. By distributing the award piecemeal, companies incentivize employees to continue working for the company over a longer term. Once a vesting date arrives, the portion of the award that is vesting becomes the employee’s stock to keep. The entire value of the vested award is taxable as income in the year that it vests, so most companies will withhold a portion of the vested award as tax withholding. For example, if 100 shares are vesting, the employee might only receive 70 shares, with the other 30 being converted to cash and sent to the Treasury as a tax withholding payment. Unless the employee is subject to trading restrictions or blackout windows due to insider knowledge of company finances, the net-of-tax vested shares can then be kept or sold as the employee wishes.
A second common stock plan involves the use of options. Stock options awards grant the recipient the right, but not the obligation, to purchase shares in the company for a prespecified price on or before an expiration date. This purchase price is known as the strike price, or exercise price, and is fixed over the life of the option (typically ten years). For example, a company may grant the option to buy 100 shares of stock for $100 per share at some point within the next ten years. If the stock flies higher than $100 over that time period, the employee will benefit from being able to buy it for below the current market value in the future. Similar to restricted stock awards, stock options grants usually have a vesting schedule where a portion of the overall award can be exercised with each vesting period that passes. These awards can be more complex than RSUs but also more flexible, as the employee can decide when to exercise and/or sell options (as opposed to an RSU that generates the taxable event automatically at each vesting date). The taxation of options transactions can also be trickier, as the type of options award as well as the lengths of time between grant date, exercise date, and sale date of the shares can all affect the tax treatment.
Finally, some companies may offer an Employee Stock Ownership Plan (ESOP) to share equity with employees. These are usually structured as qualified retirement plans with the company contributing shares of the company’s stock into a long-term account for the benefit of the employee, although these shares might not be liquid until the employee retires. The incentives are similar as other types of compensation in that the plan participant is incentivized to help increase the company’s value over time to receive a larger benefit from the ESOP shares awarded. The ESOP differs from an Employee Stock Purchase Plan (ESPP) in that the ESOP usually grants participants the shares while the ESPP allows them to elect to purchase shares—typically at a small discount to the current market value.
Once stock awards have vested and become available to the employee, a common question that arises is “What do I do with this now?”. There is no way to know for certain how the stock will perform moving forward, just like a non-employer stock, so it is important to balance the risk of having too many eggs in one company’s basket versus the potential reward if the company does well and the stock appreciates. Remember that by holding on to vested stock awards or exercised options, an employee is essentially banking a portion of their retirement nest egg fortunes on the success of the same company that is paying their salary and providing current income—not the most diversified or balanced approach! Another way to think about this is to frame the question as: if my employer paid me a cash bonus, would I use 100% of the after-tax value to buy the company’s stock? By leaving vested stock as-is, that is essentially what an employee is doing since vested awards can typically be easily converted to cash.
As more and more stock vests over time, the concentration risk in one company can grow larger than many people may realize. Not only should one factor in the currently-owned stock when considering the overall position but also any unvested stock that would benefit from a future increase in the company’s stock price. As a rule of thumb, we typically recommend having no more than 5-10% of your overall investment portfolio tied up in one company, especially if that company is also providing recurring income to the investor. By selling restricted stock as it vests, it is possible to reinvest the cash proceeds into a more diversified basket of investments to position a portfolio for long-term growth. Large blocks of vesting stock awards can also be earmarked for specific shorter-term goals, such as a new car, down payment on a home, or wedding. There are many options for redirecting the stock proceeds that can be more beneficial to a long-term financial plan than just leaving the vested stock as-is. For RSUs, because the entire award is taxed as income upon vesting, there are typically no capital gains tax consequences to liquidating the vested stock right away. Tax strategy around exercising options is more complicated and will depend on an individual’s situation and goals versus the simplicity of liquidating RSU awards as they vest.
The discussion here has mostly considered employers whose stock is publicly-traded and can be easily sold once vested. There may be fewer options for employees of private companies to divest from their equity holdings in the company and a lot of these rebalancing strategies may not apply if there is no liquid market for the underlying equity securities.
This article provided an overview of some of the more common stock-based compensation options that employees receive. While not an exhaustive list, it should provide some concepts to think about when considering how to treat these awards and factor them into an overall savings plan. We would be happy to review any specific plans in detail for clients.
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