A guide to stock plan fundamentals

Equity compensation can be complex. With a range of compensation options available to offer or reward employees, it's important to understand the different types and their implications for both your company and your employees.

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Types of equity compensation

There are several different types of equity vehicles that can be offered as part of an equity compensation plan.

What is a stock option?

A stock option is different from owning shares in a company. A stock option gives the holder the right or option to buy company shares at a predetermined price over a specific timeframe, however, does not obligate them to do so.

The strike price, or the price at which the stock option can be exercised or purchased, is determined at the time of the grant to the employee. The idea is if a company's valuation increases during this time, the employee can purchase shares at a lower price.tock options come with an expiration date.

Advantages of stock options:

Stock options provide a powerful incentive for talented leaders and employees to stay with the company and contribute to its growth. If the company becomes profitable through their efforts, they'll get a share of the rewards. Stock options can also help compensate for less competitive wages.

Stock options offer tax advantages as well. When employees exercise their options, there's no tax withholding, leaving more funds available to invest and build wealth. Also, once they dispose of their shares, either by selling them back to the company or transferring them to another employee, they only pay long-term capital gains taxes.

Disadvantages of stock options:

The biggest downside of stock options is the risk to employees. If the company performs poorly, a stock option is essentially worthless. Employees also need to remember that exercising stock options come with an expiration date.

Non-qualified stock options (NQSOs) and incentive stock options (ISOs)

There are two types of stock options – Non-Qualified Stock Options (NQSOs) and Incentive Stock Options (ISOs).

NQSOs are the most common type of stock option. These plans require shareholder approval and are usually taxed as ordinary income at the standard federal income tax rate. Unlike other forms of equity compensation, you are not required to provide specific federal tax forms in the US.

ISOs, on the other hand, are a specific type of option that qualify for special tax treatment under the US tax code. Shareholder approval is still required but there are limits on who can receive a grant and how much can be received.

ISOs are typically preferred by employees over NQSOs due to their favorable tax treatment. Take a look at the chart below for information on the differences in tax treatment between ISOs and NQSOs.

  NQSOs ISOs
Exercise Results in taxable income, regardless of method. Cash exercise; can defer income until sale.
Payroll tax withholdings Yes No – for federal or FICA
Shareholder approval required Yes Yes
Limitations of grant sizes and recipients No Yes
Tax forms required No Yes. Form 3921 required for year of exercise.
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What is a restricted stock unit or award (RSU/RSA)?

A Restricted Stock Unit (RSU) is a grant of company shares that gives employees equity in the company, but it holds no value until the shares are vested. Vesting is contingent on performance and the accomplishment of specific goals.

Once the executive, manager or employee meets the performance metrics, the shares become vested, and the units are transferred to the recipient. As the name suggests, ownership of the stock is restricted, or held back, until specific objectives are achieved.

A Restricted Stock Award (RSA) works like an RSU except the vesting is based on employee loyalty and longevity rather than performance.

Advantages of RSUs and RSAs:

RSUs and RSAs carry less risk than stock options because the recipient will always receive shares without having to pay an exercise price or incur capital gains to own them.

Disadvantages of RSUs and RSAs:

Tax filing and reporting requirements are more complex. An IPO can trigger taxes for RSUs, even if the recipient isn't ready to sell their shares yet.

What are performance awards?

A performance award is like an RSU but is tied to specific performance metrics and milestones. The company evaluates the employees performance to determine if the criteria was met and decides how many shares to award. While performance awards may include additional vesting periods, the employee owns the shares outright once granted.

Advantages of performance awards:

These awards provide a way for companies to tie equity directly to performance. They also reduce risk for the company because if the employee fails to meet performance expectations or terminates employment, there is no obligation to grant any shares.

Disadvantages of performance awards:

Performance awards can be less effective for recruitment and retention as they offer no real incentive for employees to stay during tough periods. They can also have tax, reporting, and compliance complexities.

What are stock appreciate rights (SARs)?

A Stock Appreciation Right (SAR) is an award that allows an employee to benefit from the increased value of a specific number of shares over time without actually receiving equity. Instead of getting the shares, the employee receives a cash equivalent of the appreciation. Alternatively, the bonus can be paid out in shares.

Advantages of stock appreciate rights:

Employees gain a stake in the company's performance without the complexities that come with owning stocks. Additionally, the accounting rules for SARs have been simplified in recent years.

Disadvantages of stock appreciate rights:

The flexibility and personalization of SARs can make them more complex to manage compared to other award types. Furthermore, if the company's valuation decreases, the SARs may lose all their value.

Other types of equity

In addition to the more common types of equity mentioned above, here are some additional equity options to consider:

Full value awards

Full value awards are equivalent in value to common stock, as their value matches the stock price. While less common than stock options, they are increasingly being used at large private companies.

Phantom equity and cash plans

These cash-based programs mirror the value of stock options, full value awards, or other company-specific approaches. They are most often used by private companies looking to minimize dilution impact on existing shareholders.

Profits interest

Profit interests are special tax-efficient instruments used by limited liability companies (LLCs). They work similarly to appreciation vehicles with the share value calculated based on the company’s growth.

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Supporting all major employee plan types, we are committed to expanding our partnership with you. By providing a single-partner approach, we streamline your ESPP and equity compensation plans, bringing efficiency and simplicity to your company and participating employees, while offering consistency from a trusted partner.

Contact us today to learn more about how we can help you build employee-centric high performing cultures.

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