At a time when companies are struggling to attract and retain talent, it’s more likely than ever that your compensation package may include equity. But understanding the complexities of equity compensation and maximizing this opportunity can be tricky.
IPOs (initial public offerings) are on the rise, with a record 1,033 offerings completed in the US in 2021. Equity compensation and start-ups often go hand-in-hand, especially in the technology sector, where businesses need non-salary incentives to keep key employees and significant capital to fuel their growth.
If your compensation package includes equity, you should know what that means for your finances and take the right steps to reduce risk.
The Rewards (and Risks) of Equity Compensation
Receiving equity compensation can prove lucrative, especially for companies that go on to become highly successful.
For example, Apple went public in December 1980 at $22 a share and the stock has split five times since. If you bought 4 shares at the IPO for $88 and held them, you would now have 896 shares worth $157,337 (based on the March 28, 2022 closing price of $175.60). Imagine how high that figure would be for an employee who exercised a lot of stock options (priced even lower than the IPO price)!
But for all its promise, equity compensation comes with a catch: If you’re holding a lot of equity and it becomes a large percentage of your portfolio, you could take on too much risk.
When a large portion of your net worth is concentrated in your company’s stock, it creates a potential double whammy: if the company fails (or simply stalls), your equity could be worth little or nothing and you could lose your job and income. The more equity compensation you have, the more important it is to stay diversified. (More on that later.)
How Equity Compensation Works
There are several types of equity compensation, and each has a slightly different impact when you initially receive it. Among the more common stock plans are Restricted Stock Units (RSUs) and Stock Option Plans.
- Restricted stock units (RSUs) can be a valuable form of equity compensation. You’re granted a set number of shares which vest on a schedule (typically three – four years) and as each tranche of stock vests, you automatically receive those shares. At the time you receive RSUs you pay tax on their value (based on the market value of the shares on the vesting date) at your ordinary income tax rate plus applicable employment tax (Social Security and Medicare) and any state and local taxes.
- Stock Options are another common part of employers’ overall compensation plan. Companies who award stock options to their employees are encouraging you to stay and work toward the success of the company. There are two types of stock options, Nonqualified Stock Options (NQSOs) and Incentive Stock Options (ISOs) which differ by their tax status.
- Non-qualified stock options (NQSOs) are options to purchase shares at a predetermined price (usually the market price on the date of the grant). Like RSUs they are subject to a vesting period. Ideally, when your options vest, the market value is higher than the strike price when the options were granted. If on the other hand, the market price is lower, your options are worthless. NQSOs are taxed when you exercise them, at ordinary income tax rates. The tax is based on the difference between the price at which you were granted the options and their fair market value when you exercise them.
- Incentive stock options (ISOs) are among the most complex forms of equity compensation, but they offer favorable tax treatment if certain requirements are met. You receive the option to buy stock at a price (called the “strike price”) which is determined at the time the option is granted. As with RSUs and NQSOs, there is a vesting schedule that provides an incentive to stay on board. When you exercise ISOs that have vested, you don’t pay any tax at that time, but you must hold them for at least one year from the date of exercise and two years from the grant date in order to receive the special tax treatment. There are other rules that apply to ISOs and in certain situations, a sale of ISOs can trigger Alternative Minimum Tax (AMT).
Additional Considerations when Participating in Your Company’s Stock Plan
If you work with a start-up that is approaching its IPO date, you’ll need to decide what to do with any vested RSUs or options. Maybe Wall Street is anticipating a wildly successful IPO and you’re hoping for a big payday! But, before you make a hasty move, it’s critical to understand how an IPO could affect your total financial picture.
The current share price, the forecasted share price, and any blackout periods (during which you aren’t allowed to sell) will all weigh into when you choose to sell your company stock. But two other considerations are equally important: reducing your tax liability and diversifying your portfolio to reduce risk.
Tax Liability Issues
If you receive RSUs or exercise stock options before an IPO, you can’t sell them yet because there is no public market for them. But once the company goes public, you can continue to hold the stock (in the hopes that the value will go up significantly) or sell them right away. The tax implications vary by equity type.
- When you sell RSUs, after they have vested, you pay tax on any realized gain, which is the difference between the value of the shares when they vested and their fair market price when you sell them. If you hold the shares for more than one year, you’ll pay tax at the long-term capital gains rate; if you sell sooner, you’ll pay the short-term capital gains rate, which is the same as your ordinary income tax rate.
- When you sell ISOs, you pay tax on any gain realized, which is the difference between the price when you exercised your option to buy the shares and the price at which you sell them. You’ll pay tax at the long-term capital gains rate (if you hold them for one year from the purchase date and two years from the grant date) or the short-term capital gains rate (if you sell sooner).
- When you sell NQSOs, you pay tax on the difference between the current fair market value of your shares when you sell and their value when you initially exercised them. The same one-year timeframe applies when determining if you’re subject to long-term or short-term capital gains tax. Many plans allow you to exercise and sell the options at the same time, thus avoiding the risk of holding the shares.
Asset Diversification Considerations
If you’re passionate about your work and optimistic about your company’s prospects, it can be easy to become overly confident about the future value of your equity compensation. And even if you’re holding a lot of shares and the stock surges—which sounds like a great scenario—you face the risk of having too much money tied up in one company.
If the stock takes a dive, a large percentage of your portfolio will take a hit. And while you might think there’s less risk because you have an inside track about what’s happening at your company, many external factors can influence a stock’s price—including a global pandemic, geopolitical instability, and rising interest rates.
That’s why financial advisors like the professionals at Marshall Financial Group recommend evaluating your portfolio to assess whether you have too much concentrated in equity compensation based on your portfolio value, financial goals, tolerance for risk, and investing time horizon.
If the value of your company stock is very high relative to those factors, it’s prudent to reduce your risk by diversifying your assets, which is done by selling some of your company stock. Since a stock sale will trigger a tax bill, an advisor will usually recommend trimming your exposure over several years to reduce the tax liability.
Deciding to sell some of your company stock can be difficult. You might feel very passionate about the company you’ve poured your heart and soul into. Maybe the stock is on a nice upward trajectory. Whatever the reason, letting go may be tough emotionally—but it may be the right move rationally. If you’re holding equity compensation like RSUs or stock options, schedule a call with a Marshall Financial CERTIFIED FINANCIAL PLANNER™ professional to discuss the best approach for reducing your tax liability and risk.
