Guide to what employee stock options are, what to do with them, how to manage them, and more
Startups are a breed of their own—unlike your uncle's stuffy, traditional job at a corporate office (that probably doesn't even use Google suite!). And they compensate their employees accordingly. Ever hear of the term "sweat equity"?!
Whether it's because they're new and short on liquid cash or because they want to share company ownership with employees (or both!), startups often compensate employees partially with stock options—otherwise known as equity compensation. (Psst, no, we’re not talking about your traditional calls and puts contracts.)
Equity comp is compensation that comes in the form of equity, or shares, in a company. Employee stock options differ from typical options as they’re issued by the company itself, and they can’t be traded or sold like options contracts on the open market.
While that might sound fairly straightforward, it can get a little hairy. We're here to clarify it all.
Common types of equity compensation
Equity compensation comes in many different flavors, and businesses (whether startup or traditional) have a lot of room for creativity in deciding how to customize their compensation plans.
Here are some of the most common equity compensation plans
RSA: An RSA is a restricted stock award, and these shares are officially granted upon acceptance, regardless of their vesting schedule. They give shareholders voting rights and are subject to tax from the day of grant. With RSAs, you have two choices when it comes to taxes: File a form 83(b), which allows you to pay taxes early upon receiving them at your ordinary income rate, and this is often much, much cheaper; or wait and pay a likely loftier tax on those shares throughout your vesting schedule.
RSU: Short for restricted stock units, RSUs are units of stock that are not yet granted, but rather more like promised to be granted to the employee throughout their vesting schedule. They don’t come with voting rights, aren’t taxed until vesting is completed, and they’re not eligible for the 83(b) tax option; but taxation is eligible to be deferred in some cases.
ESPP: Employee stock purchase programs essentially offer employees the opportunity to purchase company stock on favorable terms, often at a discount up to the maximum of 15%, during an offering period. Basically, they’re a much simpler version of being granted shares and just give employees a favorable opportunity to get in on owning some of the business.
Stock options: Stock options give employees, and sometimes non-employees, the right to purchase shares of company stock at a fixed price by a certain date in the future. Sounds eerily similar to options investing, right?
That was a lot, wasn’t it? Equity comp is almost as complex as an alternative investment, and in some ways, it kind of is. Not to worry though, we’ll slow it down and focus on just one for now.
Stock options are often the most common form of equity compensation out there today, so let’s zoom in a little closer on these in particular.
Zooming in on stock options
Stock options come in two flavors: incentive stock options (ISOs), and non-qualified stock options (NQSOs). There are some distinct differences between these two, and most of them have noteworthy tax implications, too.
To whom: ISOs can only be granted to employees and not anyone else, meaning no directors, contractors, consultants, or otherwise, and they cannot be transferred to anyone else.
Their limits: The IRS has placed a hard limit of $100,000 on the aggregate grant value of ISOs that could become exercisable within any given calendar year.
Their taxes: ISOs are taxed as capital gains when they’re sold, not ordinary income. If the investment is held for at least two years from grant or one year from exercise, they’re given favorable long-term capital gains treatment. Because of this, your company also won’t withhold any taxes from you upon exercising that option.
To whom: NQSOs can be granted to any number of employees, officers, consultants, contractors, or otherwise, and they can also be transferred to others in scenarios such as gifting or divorce.
Their limits: Unlike ISOs, they have no limits on the total value or aggregate number of NQSOs that can be granted to an individual.
Their taxes: NQSOs are not given the option of more favorable long-term gains tax treatment that ISOs receive, but rather are taxed as ordinary income on the spread between your option price and fair market value, and your company will withhold other necessary taxes upon exercising as well.
What do you do with these stock options?
When it comes to your options for the options, no pun intended, you have a few basic things you can do.
If you’re bullish on your company’s stock over time, you can just hold them. Just keep in mind that they’ll expire after 10 years or within about 90 days of leaving the company.
Otherwise, you have the option to essentially exercise and hold or exercise and sell those shares. Continuing to hold gives you the benefits of ownership in the company, including potential appreciation and dividends, whereas selling comes with the obvious benefit of trading those shares for cash.
Managing your equity compensation
If you’re lucky enough to have been granted some form of stock option as a form of equity compensation, you might not have noticed the details and complexities of what you’ve just been given.
Stock options come with a litany of tiny details that are important to track, and failing to do so could easily result in higher taxes, a bookkeeping nightmare, and an overall financial mess.
So, if you find yourself in possession of or in line to receive some stock options, follow these steps to ensure a smooth acceptance:
Log the grant date.
Log the grant price.
Log the number of shares granted.
Review closely the tax implications for your specific compensation.
Look closely at the information on your paystubs, and be sure to ask any questions you might have.
All in all, treat stock options just like you would the rest of your finances, with protection, planning, and care. Just imagine this unique form of compensation as an extension to your investment portfolio, one that requires a little more due diligence and accounting on the tax side of things.
It can be a lot to take in, no doubt about it, but the most important thing with equity compensation is to not panic, take it slowly, and learn all you can as you go. After all, it’s an extra little blessing that many employees don’t get to enjoy.
After that dense lesson, it's time to kick back with a lemonade and your To-Do List! Log onto the app and keep your financial plan up to date.