Equity compensation refers to a non-cash payout offered by employers to employees, providing them with a stake in the company. It may either come in the form of stock directly, stock units or the right to purchase stock in the future. Why do employers offer equity compensation? They're integral in attracting top talent to start, and it requires a minimum cash outlay by the employer in order to attract this talent. Also, with the use of equity compensation, employers can set limits on exactly when this stock is received. They can set up what's called a vesting schedule and not allow the employees to receive the stock for a certain period of time, thereby creating a carrot and stick to not only attract talent, but also retain them.
Equity compensation has been given quite an esteem in the general public, and in the eyes of the average employee. The opportunity to participate in the growth of the company is wildly attractive. Philosophically, you might think that equity compensation will help align the interests of the employees with those of the company by making the employees feel like their true stockholders and driving their commitment to the organization's success. It's the idea that employees participate and benefit from the growth and success in the company.
One of the most common forms of equity compensation is stock options. These are options that give employees the right to buy company stock at a set price, often known as a strike price. As the company grows and its value increases, employees can exercise their options, purchase shares at that stock price, thereby benefiting from the stock's appreciation. Everyone has heard the story, true or not, of the random secretary winning the lottery by cashing in her stock options from a tech startup which she had been working at for 20 years.
Established companies, both public and private, can often use something called restricted stock units as a way to reward and incentivize employees. RSU's are a grant of company stock that vest over time, meaning employees gain ownership of the shares gradually once the shares vest. Employees can sell or hold on to them, depending on their financial goals.
Now, let's discuss the potential advantages of employee equity compensation. First, it allows employees to share in the financial success of the company that they're contributing to. As the company grows and prospers, so does the value of the equity. This can have a significant financial upside, especially if private companies go public or acquired. Second, equity compensation has the opportunity to provide a substantial windfall of income for some, maybe not millions like our secretary, but several years of extra salary, which can compound substantially over time when utilizing a financial planning strategy. Many equity compensation types also have substantial tax benefits (if a proper qualified disposition strategy is used).
It's important to recognize that equity compensation is not without its complexities and considerations. It's crucial to understand the terms and the conditions of your grants, including vesting shedules, exercise periods and tax implications. Even small errors can lead to substantial losses in funds. Seeking professional advice such as a financial planner or a tax specialist, is highly recommended.
From a financial planning perspective, is equity compensation an investment or is it a way to increase your household cash flow? Does equity compensation help align the interests of the employees with their employer? And does equity compensation allow employees to feel like they have a vested interest in the company and the company’s growth? Yes…..but no.
When receiving equity compensation, the best way to look at your offer is as an extra source of income. The best strategy with equity compensation is to increase your income in the most efficient way possible, both from a tax perspective and a time perspective.
We all have a large portion of our net worth and economic identity in the companies we work for. Your base income, as well as any bonuses you might receive, your insurance benefits (e.g. life insurance, disability insurance) and retirement savings (e.g. 401k plans). You already have a lot vested in the company and plenty of reasons to want to see the company succeed. You don’t want to also have a large portion of investment assets concentrated in the company as well.
Now, that doesn't mean that the company isn't a good investment. This isn't a warning that you have to get out of the company as quickly as possible. But the goal shouldn't be to use equity compensation plans to get as much as you can out of the investment, but rather, get as much as you can in the form of an increased income stream.
It is important to understand the likelihood of future income created by an equity compensation package, based on the vesting schedule and equity compensation type. What is the greatest likelihood of this becoming income over the course of your employment period? How much of the growth or that income potential is tied to the success of the stock? How will the compensation be tax once vested and received? For future value, we can look at historical rate of returns of the stock itself if it's public, or we can look at comparisons to other private companies to determine potential value if we were to hold on to this stock until we have the ability to sell.
Once we get to a point where we can exercise and sell the stock, then the question should not be ‘should we hold on to the stock longer, because the stock might keep going up?’ The real question is ‘how do we get most of this into our pocket?’ What are some of the rules to lower the tax consequence of this equity compensation type? What are the rules for how quickly we can sell?
There's a lot of different variables that will determine exactly what this value is going to be as soon as we are able to have it in our possession, be it by exercising and selling, waiting for the company to go public or whatever the requirements may be. It is important to identify how quickly we can get this money into your possession with the least amount of taxes and opportunity costs.
In an efficient planning world, we are taking the idea of our equity compensation as an investment off the table. Yes, the company's value could shoot the moon and we could have lost out on the opportunity for a substantial gain. But, we could have just as likely avoided the potential of our company stock going down to zero and having a catastrophic event of losing our job, our income, our benefits, as well as a large portion of our net worth. In reality, it’s more likely that there will be several companies that are going to do better than our particular company in any given year. By pulling the money out of our equity compensation and diversifying it, we're giving ourselves a greater chance to grab onto whatever the big winner is for any particular year.
Equity compensation can be a wonderful opportunity to generate additional income for yourself and your future goals. But without understanding the rules and requirements tied to your equity package, or by treating it as a potential future windfall, the results may be devastating.
For more information on your particular situation, it is strongly recommended that you seek out the help of a financial professional. You can reach out to Owl and Ore on the ‘Speak with an Advisor’ page.