Stock compensation is a non-monetary payment to employees, providing them with shares or giving them the opportunity to buy shares as part of their compensation.
Many public companies and some private companies offer this benefit. Stock compensation allows companies to pay companies without spending cash, and gives employees a stake in the Company’s success. Startup companies especially can use a generous stock option program to attract employees they might not be able to afford otherwise. Let’s look at how the ins and outs of stock compensation.
Types of Stock Compensation
The two main and most common types of stock compensation are stock options and restricted stock units. Stock options give you the right to buy company stock at a discount price after a certain period. Restricted stock units are a promise to award you shares based on specific requirements.
Companies often offer employees stock options that give them the right (the option) to purchase shares at a predetermined price.
This right can be acquired over time, allowing employees to exercise options after working for the company for a certain period. When the option “vests,” that means it is available for you to buy shares in the company. Companies usually have graduated vesting, meaning you can exercise additional options if you stay with the company longer.
Stock options are a tool to build employee loyalty over time. The company could award you a certain number of options, but they might be vested over four years. After your first year of employment, you might get 25%. In year two, you might get another 25%, in the third and fourth years, you’d receive the rest.
How to Exercise Stock Options
Ownership of stock options is different from ownership of shares. Options provide you with the “option” to buy shares at a fixed price. This is called “exercising” your options. When you exercise your stock options, you take ownership of the shares and become a part owner of the business. If the value of the shares increases, you can sell at a higher price than you paid. Of course, they could also go down in value.
Companies usually use a third party to manage their stock options, so you’ll need access to that account. Contact your company’s Human Resources Manager or Finance Department to find out more about the actions you need to take.
There are several choices when exercising options.
1. Exercise and Hold
With this method, you exercise your options by paying cash for shares. You then hold the shares until a profitable exit becomes available. If your employer is a privately held company this may be your only option, as there may not be a public market for the shares.
2. Exercise and Sell
You may be able to exercise your options and sell the shares in one transaction. You would do this when the price of your shares is lower than the market price on a stock exchange. In this scenario, a portion of the proceeds will go towards the purchase and you keep the profits.
This is an option if the shares are publicly traded and the current market price is higher than your option price.
👉 Tip: A stock exchange is a meeting place (online) for equity buyers and sellers, and it acts as a market where buyers link up with sellers.
3. Exercise and Sell to Cover
Your company may allow you to exercise your options and sell enough of your existing stock simultaneously to cover the purchase cost. You sell just enough stock to pay for the purchase. This is a way to exercise options without putting up cash.
When to Exercise Stock Options
You must wait until your options are “vested. This means you wait until the date you are allowed to exercise them.
When you want to exercise your options, ensure that the stock price is higher than the exercise price. For instance, if your exercise price is $150 per share, but the stock is currently trading at $100, you’ll lose money by exercising your options. You’d be better off buying the stock on the open market.
If you do not exercise stock options before the expiry date, they will expire and you will lose your opportunity. It is not stock compensation if you never get compensated.
👉 Tip: Stock options may not be free. A stock option allows you to buy stock at a specific price. In most cases, you still have to pay for the purchase. Many options are left on the table because employees can’t or won’t pay for them.
What Happens to Vested Stock Options if You Quit or Get Fired?
You may be able to exercise vested options before you leave.
The stock options you have already exercised mean the stock shares you purchased are yours when you separate from a company, whether voluntarily or otherwise. You own the shares and the Company can’t take them back.
🤔 Common Question: What happens to unvested stock options if you leave the company?
You lose them. Unvested options are not yours after you leave the company.
Restricted Stock Units (RSUs)
RSUs are corporate shares that cannot be fully transferred to you until you have met specific requirements. Think of restricted stock units as a bonus given as stock instead of cash.
Restricted stock can be allocated based on regular purchase schedules or performance benchmarks. RSUs are issued as units that correspond to a specific number of employer shares. A unit does not necessarily equal one share.
Is an RSU a Stock Option?
At first glance, RSUs and stock options appear to be quite similar, and you might wonder whether an RSU is a stock option. Although there are similarities, the RSU and stock options are entirely different.
When you receive stock options, you have the option of buying company shares by a specific date. It is up to you to decide if you purchase the stock. RSUs, on the other hand, grant you the stock itself.
With options, you buy stock shares at a predetermined price. With an RSU you receive the stock shares, and their value is based on a company’s fair market value.
Be aware that though RSUs are “given” to you, they are counted as income. This has tax implications. It can also affect your salary. Don’t take a lower salary to compensate for the RSU benefit. Learn how to evaluate RSUs in salary negotiations
RSUs vs. Stock Option: Which Is the Better Stock Compensation?
If your company only offers options or RSUs, you don’t have much choice, but you should know the differences in case you consider a job change.
Which one is better depends on your cash situation. If you’re given an option you’ll need to come up with cash to exercise the option. That means you need to set aside investment money from your income.
There is another way to fund options if you don’t have the cash. You can have your options financed by a third party. You can make a deal with a company like EquityBee, SciFi, Liquid Stock, Quid, or ESO Fund to have them advance you the money in exchange for part of the profits. This means you don’t get all the profits yourself. Still, If you don’t have enough money to exercise an option, it may expire and you will lose the opportunity. Something may be better than nothing.
The advantage of options is you know the share price you will pay. If the price goes lower than your price, you don’t have to buy, and you didn’t lose any money because you never purchased the shares. On the other hand, if the price comes back up above your guaranteed price, you can exercise your option and have instant profit.
With RSUs, you don’t have to have cash on hand because you don’t buy them. They are a bonus that is given to you. So they are free, a substantial advantage.
You also don’t have to watch prices. You get the stock shares at fair market value when they are transferred to you. Of course, that can be a disadvantage because you won’t have a guaranteed price as you do with options, and that price could be lower than the current market value. RSUs are valued at the time you receive the stock.
So you’ve got to weigh having to buy using options or getting RSUs for free. It sounds like a clearcut choice, but remember, if your options price is low, you could profit by selling them at the higher market price.
Know how your RSUs or options will be taxed so you understand the advantages and disadvantages.
RSUs are taxed as regular income. The amount of income is based on how they are valued at the time of transfer. You will also pay Social Security, Medicare, state taxes, and local taxes.
Options, once exercised, are taxed as regular income or the Alternative Minimum Tax, whichever is higher. That is for Incentive Stock Options (ISOs). There are also Non-qualified Stock Options (NSOs) which have regular income tax withheld when you exercise them. So the main difference is you pay tax on ISOs when you pay your income tax for the year, whereas NSOs have tax withheld up front when you exercise them. Tax software can calculate your tax for ISOs and NSOs, and of course, an accountant can figure it out for you. Ask your employer which kind of options you will be getting.
You will also pay capital gains tax on any profits when you sell the stocks. This is in addition to the income tax or Alternative Minimum Tax you pay. When you sell RSU stocks, you pay the regular income tax rate on your gains.
How to Evaluate Stock Compensation in a Job Offer
Sometimes an employer will offer you a reduced salary, saying that your total income will be higher because of the stock compensation. Be careful here. It is best to negotiate salary before counting options or RSUs. Those may not necessarily turn into income.
You already know there are tax costs. Plus, there is no guarantee that stocks will go up in value.
You should ask how many options or RSUs you will receive. Though you can’t know the exact value yet, if a significant number of shares are involved, you may find this attractive.
Then ask about the vesting schedule. Determine whether you plan to stay with the company long enough to take advantage of this extra benefit.
Special Considerations for Stock Compensation at Private Companies
A public company sells shares on the stock exchanges, so they are very “liquid.” This means it is relatively easy to find a buyer.
A private company does not sell shares to the public. If you want to sell, you will have to sell your shares back to the company. Ask how the shares would be valued if you sell them back. There are brokers who can help you sell shares of a private company to investors, but this is a sophisticated and expensive method. Count on selling your shares back to your company.
Your other choice would be to hope the private company goes public so that you can sell your shares on a public stock exchange. There is no assurance that this will happen. If you’re being offered stock options at a private company you’ll need to assess whether the company is ready to go public and intends to go public. If it doesn’t you may end up taking shares you can’t sell.