Stock Compensation

Stock Compensation

What is stock compensation?

Stock compensation is a form of employee pay that uses company equity—options, restricted shares, or similar instruments—to reward, retain, and motivate staff. It gives employees a stake in the company’s future value and is commonly used by startups and growth companies that may have limited cash for salaries.

How it works

Employers grant rights to acquire or receive company stock according to set terms. Most grants include a vesting schedule that requires employees to meet time‑in‑service or performance conditions before the equity is earned. Once vested, employees may exercise options or receive shares subject to the plan’s rules and any holding or sale restrictions.

Vesting

• Vesting is the process by which an employee earns the right to stock compensation.
• Typical schedules span three to four years and can be time‑based, performance‑based, or a combination.
• Vesting may occur all at once (“cliff” vesting) or gradually (monthly, quarterly, or annual tranches).
• Only vested stock or options can be exercised or sold (subject to company restrictions and market rules).

Common types of stock compensation

• Non‑qualified Stock Options (NSOs): Allow employees to buy shares at a set strike price. At exercise, the difference between fair market value (FMV) and strike price is generally taxed as ordinary income.
• Incentive Stock Options (ISOs): Available only to employees. They can provide favorable tax treatment if holding requirements are met, but may trigger alternative minimum tax (AMT) considerations.
• Restricted Stock: Actual shares granted subject to vesting. Owners usually receive voting rights once shares are issued, but may face forfeiture if vesting conditions aren’t met.
• Restricted Stock Units (RSUs): A promise to deliver shares (or cash equivalent) when vesting conditions are met. Recipients do not have ownership or voting rights until issuance.
• Stock Appreciation Rights (SARs): Entitle the holder to the increase in stock value over a base price, paid in cash or shares.
• Phantom Stock: A cash bonus tied to the value of a set number of shares; no actual equity is issued.
• Employee Stock Purchase Plans (ESPPs): Allow employees to buy company stock, often at a discount, typically through payroll deductions.
• Performance Shares: Equity awarded only if predefined company or individual performance targets are achieved, usually over multiple years.

Exercising stock options

Common exercise methods:
– Pay cash for the shares at the strike price.
– Share‑for‑share exchange: deliver already‑owned shares to cover the exercise cost.
– Same‑day sale (cashless exercise): exercise and immediately sell enough shares to cover cost and taxes.
– Sell‑to‑cover: sell just enough shares at exercise to cover taxes and exercise price, retaining the remainder.

Practical notes:
– Private companies often restrict sales until a liquidity event (e.g., IPO or acquisition) and may disallow cashless or sell‑to‑cover methods.
– Companies typically permit only the exercise methods specified in the equity plan.

Practical example

An employee is granted options to purchase 2,000 shares at $20 each. Options vest 30% per year over three years and expire after five years. As tranches vest, the employee can buy the vested portion at $20 per share regardless of the current market price, subject to plan rules and any sale restrictions.

Tax and practical considerations

• Tax treatment varies by instrument: NSOs trigger ordinary income at exercise; ISOs may offer capital gains treatment if holding rules are followed but can create AMT exposure; RSUs are generally taxed as ordinary income at vesting.
• Taxes are generally based on FMV, and any required withholding may need to be satisfied in cash or by selling shares per plan rules.
• Consult a tax advisor for personalized guidance—equity compensation can have complex, transaction‑specific tax consequences.

Key takeaways

• Stock compensation aligns employee incentives with company performance and is widely used by startups and public companies.
• Understand the vesting schedule, exercise window, and sale restrictions before accepting or exercising grants.
• Different instruments carry distinct tax and liquidity implications—read plan documents carefully and seek professional advice when needed.