Equity Compensation: What You Need to Know
Updated: Jun 8
Restricted stock units (RSUs) often have trade restrictions, preventing you from selling them immediately. Check with HR and your advisors.
Certain types of equity-based compensation can require you to pay taxes soon after receiving it.
Stock options can be more flexible than RSUs, but they may not have any value (in the money) when you'd like to exercise them.
If you have lots of company stock and/or options, diversify your portfolio to avoid concentration risk.
In today’s increasingly competitive war for talent, stock options and other types of stock awards can be a very effective way for companies to attract and retain valued employees. From tech startups to Fortune 500 pharma companies, chances are you or someone close to you has been awarded options as a form of equity-based compensation. It makes you sound cool at cocktail parties and could turn into significant wealth (keyword “could’). Just make sure you know the hand you’ve been dealt, because you haven’t been paid directly in cash. You may have to wait a while to turn your options into liquid cash – and you don’t want too much of your wealth tied to the fortunes of a single company.
Stock Options vs Restricted Stock Units (RSUs)
Both are forms of equity-based compensation, awarded over time, typically on a vesting schedule. When you’re granted stock options, you have the option to purchase company stock at a specific price before a certain date. Whether you purchase the stock is entirely up to you. RSUs, on the other hand, grant you the stock itself once the vesting period is complete. You don’t have to purchase it.
Stock options give you the right to buy a specific number of shares of company stock at a pre-set price, known as the “exercise” or “strike price.” The option lasts for a fixed period of time, usually following a predetermined waiting period, called the “vesting period.” Most vesting periods span three to five years, with a certain percentage of options vesting each year (which means you’ve “earned” your shares), though you still need to exercise (i.e., purchase them).
RSUs are a commitment from your company to give you the value of a certain number of shares in the future without requiring payment upfront. These units are generally subject to vesting periods—typically three to four years. Unlike stock options, you don’t have to “pay” anything to exercise RSUs — once they vest, they’re yours. Just remember, you pay the income tax on these vested RSUs once they vest. More on that in a minute.
Let’s say you received company stock options a few years ago with a strike price of $10 a share. Your company is now doing well and its shares are trading at $25. So, your options are “in the money” meaning you can buy shares at $10 and sell them on the open market for $25. This nets you a $15 per share profit ($25 minus $10). But now let’s say the company is struggling and its shares are languishing around $8 a share. In this case, your options are “out of the money” and you wouldn’t want to exercise them until the company’s stock price gets back above $10. You haven’t “lost” money since you haven’t dipped into your wallet to acquire the options. But they’re not worth anything to you either.
With RSUs, by contrast, you earn actual shares in the company at regular intervals determined by the company. Those shares can be sold on the open market if the company is public (or often sold back to the company if the company is private), regardless of where the company’s current stock price is. You also receive voting rights and ownership in the company as soon as you receive your stock units. Not bad! Depending on your employer, your RSUs could have trade restrictions, such as only allowing RSUs to be sold during a trading window period. You may have to wait anywhere from a few days to weeks before selling. Consult with your Human Resource department to get a better understanding of RSU trading restrictions at your employer.
Pros and Cons of Equity-Based Compensation
The differences between stock options and RSUs can get pretty complicated. For the purposes of this post, think of it like this: Stock options are more flexible, but there’s also the risk that they won’t be “in the money” when you’d like to exercise them. RSUs are more rigid, but they’re always “in the money” since you get straight ownership upon award (i.e. receipt) at the dollar value your company has assigned to them.
Clients ask me all the time if they (or an adult child) can receive equity-based compensation if working for a private company. The answer is YES, private companies can also award this type of compensation to employees. These can be valuable if the company is on a strong trajectory. Just know you can’t get daily pricing on the value of those options since the company’s shares are not listed on an exchange. We find that private companies typically update their “share price” on a quarterly basis, but there’s no hard and fast rule.
If a private company is looking to go public -- or have some other type of “liquidity event” – there’s a chance that all shares could vest immediately. This could potentially be a huge windfall for you and will require careful tax planning. If this is something that is offered to you, we can work with you to formulate a plan around your situation.
Tax Considerations and Payment
As mentioned earlier, with most types of stock options, you don’t pay tax until you have “exercised” your options to purchase shares. RSUs, by contrast, are treated as ordinary income when they vest, so you must pay income tax and FICA tax (Medicare and Social Security) when they vest. Fortunately, there are several convenient ways to pay the tax. Most often see recipients pay via a “tender” arrangement. Say you receive an award of 100 shares of the company when it vests, the company will withhold 20 of the shares (20%) and sell them on your behalf. That way the proceeds can cover your tax obligation on the remaining shares. Some companies require you to set it up that way. At other companies, you can pay out of pocket if you have the money or even pay the tax as a paycheck deduction.
Minimize Concentration Risk
When it comes to stock options, there’s not much we can do to help you with your tax obligation, but there is a lot we can do to help you diversify your portfolio, so you don’t have too much of your wealth tied to the fortunes of a single company (i.e., your employer). It’s great you believe in the future of your company. But as you accumulate more and more shares, you increase your concentration risk. That can put a big dent in your portfolio if the company starts to falter. Sadly, we’ve seen this happen many times, and it’s not just to employees of startup companies. Even mighty companies that have been in business for over 100 years can suddenly collapse or face significant business reversals (remember Enron, AIG, Lehman Brothers, or General Motors?). With that backdrop in mind, we can help you diversify your holdings so you’re not taking on unnecessary risks with your nest egg.
Conclusion If you or someone close to you has concerns about your equity-based compensation or portfolio allocation, please don’t hesitate to reach out. We’ve helped many clients like you in similar situations.
RYAN A. DUNN, CFP®, Wealth Manager at Novi Wealth