Key takeaways
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Equity compensation comes in various packages. In this article, we’ll define some of the most common forms of stock-based compensation issued by startups and established companies alike, including RSUs, ISOs, NSOs, and more. By understanding these concepts, you’ll be on your way to having the knowledge you need to make informed decisions about equity compensation packages, and understanding how Harness can help.
Table of contents:
- What is equity compensation?
- Restricted Stock Units (RSUs)
- Restricted Stock Awards (RSAs)
- Incentive Stock Options (ISOs)
- Non-Qualified Stock Options (NSOs)
- Employee Stock Purchase Plan (ESPP)
- Qualified Small Business Stock (QSBS)
- 83(b) Election
- Stock compensation FAQs
What is equity compensation?
Equity-based compensation (also called stock-based compensation, stock compensation, or share-based compensation) is a way of paying employees, executives, advisors, and directors of a company with equity or stock in the business instead of cash. It is typically used to retain employees, align employee interests with the company, and provide employees additional compensation beyond their cash salary.
Equity compensation can be in the form of Restricted Stock Units, Restricted Stock Awards, Incentive Stock Options, Non-Qualified Stock Options, and Employee Stock Purchase Plans.
Summary of equity compensation
Equity compensation, or stock-based compensation, typically falls into three categories: Restricted Stock, Stock Options, and Employee Stock Purchase Plans.
Types of stock-based compensation |
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| Stock-based compensation type | Stock-based compensation details | |
| Restricted Stock | Employees receive Restricted Stock Units (RSUs) or Restricted Stock Awards as compensation. | |
| Stock Options | Employees have the option to purchase shares of company stock at a predetermined strike price. | |
| Employee Stock Purchase Plan | Employees can purchase shares of company stock at a discounted price on a set schedule through payroll deductions. | |
Restricted stock
1. Restricted Stock Units (RSUs)
If you work for a publicly traded company or a startup preparing for an IPO, chances are your equity compensation comes in the form of Restricted Stock Units (RSUs). RSUs are shares of common stock that are granted to an employee over a period of time known as a vesting period, which typically spans three to four years. The vesting period represents the time between the issuance date when the shares are awarded, and the vesting date when the RSUs are officially transferred to the employee.
Keep in mind that when you’re initially awarded RSUs, you don’t actually own the shares, because you need to wait until the completion of your vesting period. Additionally, because the shares are not your property until the vesting date, no taxes are owed until the vesting date. But depending on the value of your shares and the growth of the company you work for, you could be on the road to a rather hefty tax bill.
How are RSUs taxed?
There are two distinct taxable events associated with RSUs.
- The first is when your RSUs vest, which will be reported as ordinary income and require you to pay standard income tax. That income will be reported on your W-2 form issued to you by your employer.
- The second taxable event is when you sell your RSUs, which will trigger either short or long-term capital gains tax, depending on how long you held them before selling. Income from the sale of RSUs will be reported on a 1099-B Form.
Double-trigger RSUs
Taxes on RSUs have the potential to be very high, sometimes even exceeding the amount of cash that the benefitting employee has on hand. To account for this, companies will sometimes require—in addition to a vesting period—a liquidity event such as an IPO to take place before RSUs can fully vest. This is known as a double-trigger RSU and ensures the employee has an opportunity to sell their shares in order to cover their tax bills immediately on the vesting date.
One recent example of a company issuing double-trigger RSUs to its employees is Stripe, the payment processing platform. Stripe was founded in 2009 and has raised billions of dollars from investors over the years, but it has remained a private company. In 2023, Stripe raised $6.5 billion to facilitate a tender offer for its early employees with double-trigger RSUs expiring in 2024..
2. Restricted Stock Awards (RSAs)
Restricted Stock Awards (RSAs) grant an employee shares of company stock upfront, subject to a vesting schedule, and certain restrictions. Unlike RSUs, RSAs represent immediate ownership in the company, which means the employee has voting rights even during the vesting period.
How are RSAs taxed?
RSAs are taxed at the time they vest. The fair market value of the shares on the vesting date is treated as ordinary income and subject to taxes. If the employee chooses to make an 83(b) election, they can elect to pay taxes on the total fair market value of the shares at the time of grant, rather than waiting for the shares to vest. This can be advantageous if the employee expects the value of the shares to increase significantly over the vesting period.
Stock options
1. Incentive Stock Options (ISOs)
Incentive Stock Options (ISOs), and options in general, differ greatly from grants and awards, as they require employees to purchase the shares upfront, instead of just being issued them. ISOs, sometimes also referred to as Qualified Incentive Stock Options, are a type of option that can only be granted to employees.
ISOs have a strike price, which is a set price at which employees are able to purchase company stock at a future date. Should the employee exercise and then later their stock, the capital gains will be calculated based on the difference between the strike price and selling price.
How are ISOs taxed?
ISOs are taxed as capital gains and are only taxed when the shares are sold. As is typical with capital gains taxes, selling after less than one year will trigger the short-term capital gains tax rate, whereas holding for more than one year will result in a reduced long-term capital gain tax rate. The taxable amount owed is calculated based on the spread, or difference between, the strike price and selling price, or fair market value (FMV).
ISOs are not taxed as ordinary income. However, if your income from the sale of your ISOs outweighs your normal income for the year, you may have to pay Alternative Minimum Tax (AMT).
2. Non-Qualified Stock Options (NSOs)
Non-Qualified Stock Options (NSOs) are typically issued to non-employees, such as board members, advisors, or consultants. NSOs are also issued to employees if they reach the annual IRS limit for ISOs, which is currently $100,000 per employee per year.
There are a few key differences between ISOs and NSOs when it comes to taxes:
- NSOs are taxed both when they are exercised and when they are sold.
- NSOs are not subject to Alternative Minimum Tax.
- NSOs, unlike ISOs, are considered ordinary income, and taxed as such
Employee Stock Purchase Plan (ESPP)
An Employee Stock Purchase Plan (ESPP) is a company-run program that allows employees to purchase company stock at a discounted price through payroll deductions over a set offering period. ESPPs may offer a “look-back” option which allows employees to buy shares at a lower price point, often at the stock price at the beginning or end of the offering period, whichever is lower. ESPPs incentivize employees by offering potential financial gains through stock ownership and aligning employee interests with company performance. Participation in an ESPP is voluntary and is designed to be an employee benefit.
Strategies to reduce equity compensation tax consequences
1. Qualified Small Business Stock (QSBS)
The QSBS exclusion is not a form of equity compensation, but rather a tax benefit that allows founders, certain early investors, and employees to be subject to lower tax rates or even exemptions, potentially up to 100% of capital gains up to $10 million. To qualify for QSBS in 2024, companies must meet certain criteria, including being a US-based C corporation and not having more than $50 million in business assets. QSBS only applies to stock, and any options must first be exercised before converting into QSBS-eligible shares.
2. 83(b) Election
An 83(b) election allows employees to pay taxes on the value of their equity compensation at the time of issuance, rather than waiting for the equity to fully vest. An 83(b) election can be particularly beneficial if the value of the equity is expected to rise significantly during the vesting period. However, the 83(b) election carries risks and should be carefully considered with the help of a financial advisor.
Stock compensation FAQs
What is the risk of equity compensation?
Equity compensation, while offering the potential for substantial financial rewards, carries inherent risks such as market volatility, which can significantly affect the value of equity awards like stock options or RSUs. Employees also face risk if they have too much of their wealth invested in their employer’s stock, potentially leading to significant losses if the company’s stock declines. Additionally, vesting schedules can impose restrictions on when equity can be fully owned or sold, and the complex tax implications of stock compensation can lead to unexpected tax liabilities. Understanding these risks is crucial for employees to navigate equity compensation effectively.
How is equity paid out to employees?
Equity compensation is paid out to employees in various forms, such as stock options, restricted stock units (RSUs), or shares through an Employee Stock Purchase Plan (ESPP). Stock options give employees the right to purchase company stock at a predetermined price after a certain period, known as the vesting period. RSUs are company shares given to employees as part of their compensation, but they only become fully owned by the employee after meeting certain conditions, typically related to tenure or performance milestones. ESPPs allow employees to buy company stock at a discount, often through payroll deductions over a set period. Each of these equity types is subject to specific rules regarding taxation, vesting, and selling restrictions, impacting how and when employees can realize the financial benefits from their equity compensation.
How do you value equity compensation in a private company?
Valuing equity compensation in a private company is complex due to the lack of a public market for the shares. Typically, private companies will use a fair market value (FMV) assessed by an independent third-party valuation, in accordance with IRS Section 409A, to establish the value of their stock. This 409A valuation considers various factors, including the company’s financial health, its projected future cash flows, recent transactions of company stock, and comparisons to similar businesses in the industry.
Harness can help navigate equity compensation
If you’ve been offered equity compensation or need help making the most of the equity you’ve already been issued, work with an experienced financial advisor who can help you make sense of it all.
Harness specializes in working with startup employees, founders, and other modern workers on unique tax and financial planning strategies for the long term. By working with Harness, you get the support and expertise you need to make informed decisions about your stock-based compensation package and work together on a financial plan that meets your unique goals and needs. Sign up today to get started with Harness.
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This document does not constitute advice or a recommendation or offer to sell or a solicitation to deal in any security or financial product. It is provided for information purposes only. To the extent that the reader has any questions regarding the applicability of any specific issue discussed above to their specific portfolio or situation, the reader is encouraged to consult with the professional advisor of their choosing.
Past performance is not indicative of future results. All investments have risks and have the potential for profit or loss. Equity investments are volatile and will increase or decrease in value based upon issuer, economic, market and other factors. Options are complex securities that involve risks and are not suitable for everyone.
