Investing & Retirement | August 2024 Understanding Equity Compensation

Early in your career, salaries and bonuses were likely your main sources of compensation. But as you rise higher in the ranks, you may start to receive incentive stock options, non-qualified stock options, restricted stock units, and other forms of equity compensation offered to senior employees.

Whether equity compensation is already a portion of your pay or you anticipate receiving some form of it for the first time, understanding how all forms of executive compensation blend with your other assets is an integral part of building a balanced personal wealth plan.

Beyond that, you may want to become more familiar with the key considerations to make when you’re weighing offers. An overview of pros and cons of the most common forms of stock-based compensation can help you navigate some of the more complex aspects of the process.

Assessing an equity compensation offer can often be a complicated and meticulous process. It’s important to be able to cut through the noise of clauses and details to determine whether an offer is a good fit for your current finances and an effective way of achieving your future goals.

The simplest way to accomplish that is to examine your equity compensation plan using three key considerations:

1. Valuation: If you receive an offer from a publicly traded company, determining the dollar value of your offer should be as straightforward as checking daily stock quotes. But for closely held companies, independent, non-transparent methods determine equity value—all of which are updated less frequently than public companies.

“If you’re receiving valuations of your equity compensation just once or twice a year without any idea of how it’s calculated, it’s worth considering the effect it could have on your ability to time executions and maximize value,” says Chad Forsberg, a Truist wealth business owner planning strategist.

2. Timing: Vesting schedules attached to certain forms of equity compensation create timed periods of release—typically across three years—for fixed amounts of shares. Some forms stipulate the number of shares to be released based on the attainment of financial benchmarks. Others have 10-year expiration dates, after which the shares available to exercise go to zero. It’s important to pay attention to timing restrictions alongside your projected income.

“Those are fixed dates and limits that you can’t control or alter,” says Truist wealth strategist Paul Giliberto. “In the event that you need capital quickly, you might not be able to access it through stock options or restricted stock. Or if you leave the company before a vesting period, you might not realize any of that value.”

3. Taxes: The tax treatment of equity compensation varies. “With certain forms, you pay taxes when they vest as opposed to when you exercise the stock or option. With other forms, you have to pay when you exercise or sell,” says Forsberg. “For financial planning, it’s important to determine upfront the tax implications for vesting and what the tax consequences will be when you finally own the shares.”

Considering a compensation offer through the lenses of valuation, timing, and taxes will ensure you’re also answering fundamental wealth planning questions: How much money do I need to live on? If I need money suddenly, how hard will it be to access? When and under what conditions will I be paying taxes, and from where should I pull the money to pay them?

The four most common types of equity compensation—stock options, restricted stock units, performance shares, and employee stock purchase plans—have certain features in common. Despite these similarities, each also has unique benefits and drawbacks that will help you judge the quality and feasibility of a given offer in relation to your personal finances.

Stock options
 
Upside: Of all forms of equity compensation, options have the greatest upside potential. “If the company does well, you’re going to participate in that performance at a multiple because you’re using the difference between the price at the time of granting (strike price) and the value when exercised to make a profit,” says Truist Wealth advisor Tom Schauder. “For example, a 2% increase in the underlying stock price would result in a much higher increase to the option value.”

Downside: If the value fails to go up on your options, you might not have the opportunity to realize any appreciation. You could end up “underwater,” where the strike price of the option exceeds the market value of the stock. “Since options come with expiration dates, there’s also the possibility you hold too long and either miss chances to optimize or sail past the expiration date and are left with nothing,” says Schauder. “And if your options are with a closely held company, you won’t have their market value published every few seconds, which gives you a much smaller window to effectively exercise your equity compensation.”

Restricted stock units (RSUs)

Upside: Unlike stock options, RSUs don’t include an exercise price. “You don’t have to buy shares at a certain price then turn around and sell them at a higher price to realize value,” says Schauder. “Whether the stock goes up or down, with an RSU there are more guarantees that you’re going to realize the value of it, because they just vest at a certain point in time, and as they do, you’re awarded full value.”

Downside: The structure of RSU vesting schedules can potentially result in compensation not realized if you leave the job. “If you get 100 shares that vest 25% each year over a four-year period, you’re always going to have stock ahead of you that’s dangling like a carrot,” says Schauder. “Your equity compensation offer may state that if you work for the company for 10 years, are over the age of 55, and decide to retire, that 100% of unvested stock will immediately vest. But if it doesn’t and you leave the company for another job, you’re going to be leaving some of your compensation on the table—which can make RSUs a type of employee retention tool.”

Performance shares

Upside: In addition to having no exercise cost like RSUs, performance shares have the potential to deliver big if your company has exceptional performance. “If your employer has a fantastic quarter or year and hits the performance metrics like return on equity or earnings per share that activate your equity compensation during the assigned vesting periods, you might get 175% of the target shares your employer granted you initially,” says Schauder.

Downside: Performance shares are delivered in stipulated targets. This adds to the amount of activation benchmarks that are out of your control and can make realizing the value of your equity compensation much more difficult. “If I’m an executive coming into a company and the only form of equity compensation I’m being offered is 1,000 performance shares, I’m not necessarily excited,” says Schauder. “If the company doesn’t meet certain financial metrics outlined in the performance share agreement, then instead of 1,000 shares rolling out at the defined vesting periods, I might get only 750 shares three years down the road when benchmarks are hit.”

Employee stock purchase plan (ESPP)

Upside: ESPPs don’t have a vesting schedule, and while the stock has a cost to the employee, the purchase price is discounted. With ESPPs, compensation isn’t locked up in quite the same way it is with other forms of equity compensation. This key difference enables you to realize the value of ESPP equity much faster in many—if not most—scenarios. “While still operating within certain parameters, purchasing stock at a 15% discount means you can turn around and sell at an immediate gain if you need money quickly,” says Giliberto.

Downside: You’re putting up your own money. There are annual caps on how much stock you can purchase. There are limits on the number of times you can make a quick sale. And there’s often a structured delay between when you purchase and have control of the stock. “So, if you’re purchasing the stock through automatic deductions from your salary that accrue over a six-month period—which is not uncommon—you’re forgoing that portion of your paycheck in after-tax dollars, losing access to cash until the point you can sell the stock,” says Giliberto.

The initial work you put into understanding equity compensation enables you to accept an offer that aligns with your current finances and helps you reach your goals. But even if you make the most favorable selection and get the best terms, optimizing your equity compensation is an ongoing process—and managing it becomes more complex as your net worth increases.

Some of that complexity exists from the start of accepting your offer in the form of day-one trade-offs that should be spotted early, planned for, and monitored.

“A fantastic equity compensation plan that lines up in every way with your circumstances and goals and provides a significant amount of RSUs might not allow the transfer of unvested shares to your spouse in the event of your sudden passing,” says Forsberg. “Turning down all that upside on the basis of something that may or may not occur isn’t necessary—a wealth advisor can help engineer solutions like purchasing life insurance that allows you to take the compensation while offsetting that risk.”

Other questions to consider:

• What is the long-term financial prognosis of the company, and how does that impact your ability to maximize your compensation?
• Will an equity compensation package leave you overconcentrated in employer stock or options?
• What are the minimum and maximum possibilities for your income through the compensation package, and how does that compare with the cash compensation you could be offered by a different company?

“There are so many situations like these, and in each of them having a wealth advisor to help thread the needle can make all the difference,” says Giliberto. “You understand your financial needs and goals better than anyone else. But having a bit of professional help can ensure you manage your time as well as your money.”