There is a difference between just earning a paycheck and being a part of something bigger - owning a piece of a company's future success and growth. This is what equity compensation offers.
Understanding Equity Compensation
Equity compensation is a straightforward concept. It is the distribution of ownership shares in a company to its employees. The idea behind equity compensation is that you will own a fraction of the company and can benefit from its growth and success. Equity comes in different formats such as stocks, stock options, and restricted stock units (RSUs). Knowing which type of equity you have and how it works is essential.
One common format of equity compensation is stock options. Stock options allow an employee the right to buy a certain number of shares at a predetermined price (also known as the strike price). Vesting schedules determine when you can exercise your stock options.
For example, let’s say your company grants you stock options over a four-year period with a one-year cliff vesting schedule. It means you won’t be able to exercise any of your options until you've been with the company for at least one year, and it will vest over the next three years (usually quarterly). Bottom line: it is essential to understand the terms of your equity compensation and your options before exercising them to avoid any unexpected tax implications.
Restricted Stock Units
Another type of equity compensation is restricted stock units (RSUs), which grants you a specific number of shares after a vesting schedule. RSUs are not options but the actual shares of the company that vest over time. Once the RSUs are vested, you'll pay taxes on their fair market value on the vesting date. This means you don't have to purchase the shares like you would with stock options and can sell them right away. However, this strategy might not be beneficial if you believe in the company's potential growth and don't want to sell your shares.
There are two types of equity: non-qualified equity and qualified equity. Qualified equity, such as incentive stock options (ISOs), offers tax advantages compared to non-qualified equity. With ISOs, you won't have to pay taxes until you sell the stocks, and potential profits will be taxed at capital gains tax rates. Non-qualified equity, on the other hand, has no tax benefits as they are taxed as ordinary income at the time of exercise or vesting.
Ultimately, equity compensation provides an invitation to be part of something significant, an opportunity to align interests, and participate in a company's upside. It's a game-changer for employees who want to take ownership in their future success and growth. If equity compensation is an option for you, we are here to answer your questions and we encourage you to speak with a tax professional so that you’re fully informed.