Demystifying 3 Key Types of Stock Based Compensation

compensation and benefits Dec 10, 2023
man holding phone reviewing his stock based options on multiple devices

Ever wondered whether you should get excited about stock based compensation?

Imagine this: You've just landed your dream job at the next big tech start-up.

The pay is decent - perhaps a little lower than you hoped - but there's something else on the table – stock based compensation.

Like stock options. Or maybe RSUs.

Or was it something else?

Anyway, it's pretty cool, amirite?

Maybe it is, and maybe it isn't. And you're not alone if you're unsure about what stock based compensation really means or how to value it.

In this post, we're going to dig into the complexities of several kinds of equity compensation, including stock options, RSUs, and ESPPs. We'll also talk about how to think about the true value of stock compensation to make sure you're signing up for a compensation package that meets your needs.

Oh, and we'll also expose some gotchas to be aware of, too. Buckle up, because this ride could potentially change how you view your income forever!

What is stock-based compensation and why do companies offer it?

Stock compensation is an agreement where businesses give employees part ownership through stocks or options. But why do they offer this sweet deal? Simple.

They want to keep you around.

The idea here is to attract and retain top talent and motivate employees. When your paycheck has the potential to grow with company success, sticking around seems more appealing than jumping ship at the first sign of trouble. This strategy also motivates you to work harder because your financial well-being directly links with how well the company performs.

This isn't some new-fangled concept either; many tech giants such as Google and Facebook have been using this method for years.

Stock compensation packages can come in different flavors too - from Restricted Stock Units (RSUs), which grant actual shares over time, to Stock Options, which give you the opportunity to buy shares at a fixed price, to Employee Stock Purchase Plans (ESPPs), that let you buy shares at discounted prices.

Be aware, however, that stock compensation packages come with tax consequences. Plus, if things go south for your employer...well let's just say your net worth can take a hit.

So when considering job offers with stock comp versus straight cash salary – think hard about what suits you best.

What Are Stock Options?

Picture stock options as the key to a treasure chest. They give you the authorization, but not a requirement, to acquire equity in your company at an established cost. This fixed price is often called the 'grant' or 'strike' price.

Here's where it gets exciting: If your company’s share value rockets beyond that grant price? Congrats! You're sitting on potential profit.

But if it plummets below? No worries—you can choose not to use your key and leave that chest locked up.

The real magic happens during what we call the vesting period. Think of this like waiting for cookies to bake in an oven—except instead of delicious treats, you get stocks. Typically spread over several years, this timeframe dictates when the goodies become yours for the taking.

Vesting Schedules & Exercise Periods

When dealing with stock options, you've got two significant dates to keep an eye on: The vesting date and the exercise deadline.

The vesting date marks when all those tasty stocks are fully cooked and ready to buy.
The exercise deadline is like last call at the bar—it's the cut-off point for buying your shares before the lights come on and the barkeep says "You don't have to go home, but you can't stay here."

Taxes On Stock Options

Tax time doesn't have to be taxing when you have stock options —it just requires understanding how Uncle Sam views stock options. Two types exist - nonqualified stock options (NQSOs) and incentive stock options (ISOs). Each has its own tax implications. But let's save that juicy topic for another day...in the meantime - consult your accountant.

What Are Restricted Stock Units (RSUs)?

Restricted Stock Units, also known as RSUs, are a type of equity compensation given to employees. In essence, RSUs are company shares that you can't sell or transfer until they're vested—that is, until certain conditions have been met. It's like getting a fancy gift box with instructions not to open it just yet. You've got the gift (the stocks), but there’s an attached string (vesting period).

The value of these mystical RSUs isn’t determined by strike prices—unlike their cousin 'stock options'. They’re valued at the market price on vesting day. So if your company’s doing great and its share price is sky-high when your RSUs vest... cha-ching.

Taxes and Your RSUs

A question that might be bugging you: "How do taxes work with my dear friend Mr. RSU?"

The good news is that taxes aren't due when you get those shiny new shares; instead, Uncle Sam comes knocking when your RSUs vest. RSUs are taxed as ordinary income based on fair market value the day they vest.

Vesting Schedule – No Rush Here

Your patience game needs to be strong because typically companies set up a 4-year cliff-vest schedule for these restricted beauties. Meaning only after year one will any part start becoming yours truly. Remember: good things come to those who wait.

What Is an Employee Stock Purchase Plan (ESPP)?

An Employee Stock Purchase Plan, or ESPP, is a perk some companies give to their employees. Think of it like getting VIP access at your favorite concert - but instead of backstage passes and free drinks, you're getting discounted shares in the company where you work.

The way it works is pretty simple: You set aside a part of your paycheck before taxes are taken out.

That money gets used to buy stock in your company at a discount - typically around 15% less than what everybody else pays.

This isn't just about saving money on buying stocks though. The real benefit comes when the price goes up because then those cheaper shares could be worth more.

But remember this: ESPPs aren’t guaranteed cash cows. Investopedia warns, "If the company's stock does not perform well, participants can lose money."

To protect yourself from potential losses with an ESPP or any other investment plan, always make sure that you diversify by investing in different types of assets. Don't put all your eggs into one basket...or rather one stock.

Navigating Your Company’s ESPP

Your employer will give you the information on how much to contribute and when they'll buy stocks for you—these particulars could be different depending on the company, but it's pretty common for companies to purchase stock on your behalf every 6 months.

If deciding whether to participate feels daunting, consider asking these questions:

  • How long do I have to hold onto my purchased stocks?
  • What's the impact if I were to leave my job soon after the purchase?
  • What happens if I'm laid off from my job?

Do your research and potentially seek counsel from a financial advisor or accountant, as each circumstance is unique.

How Should Employees Value Their Stock Compensation?

If you're offered stock-based compensation, don't just jump in without being sure you understand it.

Equity compensation can seem like winning the lottery, but remember this - it isn’t cash-in-hand until it’s vested and sold. So let's break down how to determine its real worth.

Consider The Current Market Value

It's easy to get caught up in what *could* happen to a company's stock price, which makes it really wise to understand the current market value of your stocks. This figure will give you an idea of what your payout could look like if everything stays steady.

Predicting Future Company Performance

This part gets trickier because predicting company performance involves crystal-ball-gazing into future growth rates and industry trends. If your company's rocketing up faster than Elon Musk's SpaceX Starship, that stock might soon be more valuable than gold dust.

If you're considering working at a company that is touting how they are "scaling so fast" and "will be a unicorn IPO", it's completely fair to ask for more details about why company leaders believe this growth will happen. Don't just fall for hype - ask for details!

Tax Implications

Last but not least – taxes. Yes, Uncle Sam wants his share too. Depending on when you sell your shares or whether they’re options or RSUs, tax implications vary widely. Here is some help navigating those choppy waters.

Don't Forget About Total Compensation

Navigating the details of stock-based compensation can make it easy for people to be distracted from another number - total compensation. Total comp includes the value of all cash compensation (including bonuses), benefits, and stock compensation.

When including stock-based compensation in your total comp calculations, consider using a range, from conservative to more aggressive. When I've done this for myself and my clients in the past, I've typically calculated 2 or 3 ways. One option was always the current value of the stock. You can also calculate using a pessimistic number (like maybe $0) and an optimistic number.

Valuing stock comp seems as complicated as a Rubik’s cube at times (with more variables), but knowledge comes with power. Arm yourself with information before making any decisions, and don't be afraid to consult with an expert if you're confused.

What Are Some Common Gotchas With Stock Compensation?

You might think that stock compensation is all rainbows and unicorns. Be mindful, there are a few snags you should know about before taking stock compensation.

The first gotcha is the 'golden handcuffs' effect. You're essentially tied down to your company until your stocks vest, which could take years. If you leave early? Bye-bye stocks.

A second tricky aspect involves taxes. Yes, Uncle Sam wants a piece of this pie too. RSUs are taxed when they vest while options get taxed when exercised. When you consider that different RSU or stock option grants can have different timeframes, it's important to keep your eye on the ball.

Last but certainly not least: market volatility. Just because you have a bunch of shiny new shares doesn't mean their value will always go up - it can plummet just as easily. Just ask literally everyone who went through the Tech Wreck of the early 2000s!

To avoid these gotchas with stock compensation, make sure to understand what type of stock award you’re getting, when you're getting it, and how it’s being taxed.

Gearing Up To Tackle These Gotchas

If this seems like an overwhelming maze, don’t fret – help is at hand. Financial literacy resources like Khan Academy's Guide on Stocks or the Employee Stock Option Fund's (ESO Fund) blog can help you navigate these waters. I also love Investopedia for learning about financial topics of all kinds.

Remember, stock compensation is a potentially lucrative part of your package. But just like the delicious candy in a pinata, it takes some strategic whacks to get at the goodies.

Should I get excited if a company offers me stock compensation?

If you've been offered stock-based compensation, it's natural to feel both thrilled and a little unsure. The promise of owning part of the company can be exciting.

Stock compensation, in its various forms like options, RSUs or ESPPs, represents potential wealth.

However, there are no guarantees - just ask anyone who held Enron shares.

The worth of these stocks is contingent on the corporation's success in the long run. It’s kind of like betting on a horse race: some bets pay off big time while others might not make any difference at all.

  • You could become wealthy if your employer becomes successful.
  • Your income may fluctuate with market conditions.
  • Taxes related to these compensations can be complicated and hefty at times.

Also - it's equity isn't the only compensation factor that matters LINK THIS TO COMP AND BENNIES GUIDE POST - not by a long shot. Everyone has different needs and risk tolerance. If you'd rather have more cash up front instead of stocks - that's OK. It's your career and your financial picture, not anyone else's.

Final Thoughts on Stock-Based Compensation from a No BS Career Coach

Stock-based compensation can be a game changer. You've seen how stock options, RSUs and ESPPs work.

You've learned to think beyond just the cash part of your compensation and better understand the potential worth of those stocks in your hand.

We dug into common pitfalls too so you can be prepared to make smart decisions.

Finally, remember that excitement over being offered stock comp? Keep that feeling but temper it with practicality and foresight.

Stock-based compensation isn't magic money—it requires strategic thinking—but boy can it change your financial future if played right!