Stock Options and Equity Compensation: What You Need to Know
Posted by: Joseph Kuo | October 12, 2022
Stock options and Restricted Stock Units (RSUs) are the two most common ways of awarding equity compensation to a company’s employees. From the newest startups to the most well-established tech companies, most will feature some form of either equity compensation as a key feature of their employee pay packages.
Own A Piece of Your Company, But…
Stock options/RSUs are awarded to enhance an employee’s standard compensation package, to reward for great job performance, or to encourage a valued employee to stay. There are some very key caveats though that make equity compensation significantly different from cold hard cash.
Most grants of equity compensation, whether they are options or RSUs, will come with a vesting schedule. This means you have to wait a certain amount of time before they are fully available to you to cash in.
As their name implies, stock options are not an outright award of stock. Rather, they are a formal offer that allows you to purchase a number of shares of company stock at a specific price. RSUs in contrast are actual grants of company shares, although they may be of a different class than ordinary shares. Either way, until you sell the shares you get, you won’t actually see any money.
Don’t forget also that if your company is public, you will owe tax on RSUs when they vest. If you have options, you do not owe taxes until you exercise the options and actually buy the shares.
If you are at a company which has not gone public yet, or if you work in certain roles with access to insider information, there may be additional “blackout” periods during which you are not allowed to exercise stock options or sell RSUs.
The amount and per share value of your equity compensation will vary widely. Factors such as when the company’s current stage of development and your initial title and responsibilities all factor into the amount of equity compensation received when you first join a company. Subsequent awards of equity compensation will factor in overall job performance as well as length of service.
Once a company has gone IPO and is publicly listed on the stock market, the value of the shares will change daily. Share prices can fluctuate wildly over time depending on the company’s fortunes and the overall mood of the stock market.
If you hold a large number of options or RSUs, your financial success and net worth becomes heavily tied to the success of your employer. While this company may be a well-managed company with amazing products/services, it is not immune to bad luck, mistakes, and the broader economic cycle.
Equity compensation comes with a myriad of tax consequences. The specific type of equity compensation and when you actually sell the shares can drastically affect the amount of taxes you will have to pay and when. Depending on the situation, you may have to pay the taxes out of pocket when you first gain the shares, when you sell the shares, or when you file your tax return. In general, shares held for less than a year are taxed as ordinary income, and if held more than a year will qualify for the long term capital gains tax rate of up to 20%.
As an employee-owner of the company, you will have an extra emotional investment and motivation in the value of your equity compensation. If you believe in your company’s future growth and success, you might feel particularly reluctant to sell your shares. Over time, this mindset results in a heavy concentration of your net worth in your company’s stock and the resulting financial risk. But if you don’t sell the shares at some point, you will never realize their value.
Since this concentrated position is in the company you work for, you are adding your human capital risk on top of your financial risk. Since you also receive your salary, bonus, and other benefits by working there, any negative disruption to this one company will have an outsized impact on many aspects of your life at the same time.
You might also feel obliged to stay at the company longer than desired in order to get the full number of shares granted. Some call this feeling the “golden handcuff” effect. It’s a big reason why companies use stock options/RSUs with a vesting schedule in order to help with employee retention.
Potentially Life Changing Wealth
There is one additional consideration that is not unique to equity comp but may also create a big impact to our lives: the potential for a sudden and large influx of wealth. If your company meets or exceeds its goals and performs well on the stock market over the years, your equity compensation could see tremendous growth. While this would be a great thing for our net worths, the resulting effects on our lives can be chaotic and stressful. The gotchas of equity compensation can be extremely complicated. But if managed astutely, they can potentially provide life changing wealth.
Many clients have come to me asking me to help them manage their equity compensation plans. I not only manage such plans, but I work to integrate them into my clients’ overall financial portfolios to help them accomplish their life goals.
A question I often get is “are my stock options/RSUs enough for me to retire?” As a tech industry veteran myself, I’ve had a lot of experience both figuring this out for myself as well as working with clients to help them figure out the answer.
I’m putting together a white paper that outlines the things you should think about in making such a drastic decision, along with some simple methods to do a back-of-envelope estimate on your own. To download this white paper, just sign up here.