About the author: Lamar Watson, CFP®, is a Fee-Only Financial Advisor in the Washington, D.C., area who works with clients virtually across the country. Dream Financial Planning is a Fiduciary Financial Planning firm specifically designed to help individuals in their 30s and 40s take control of their finances and fulfill their dreams. Feel free to schedule a Free Consultation to learn how we use the DREAM Financial Planning Process ™ to help our clients achieve their goals.
Equity compensation is an attractive benefit that many companies offer to employees. It can be a valuable way to reward and motivate employees by giving them a share of the company’s ownership. If you’re new to equity compensation or simply looking to learn more, you’ve come to the right place. In this article, we break down what equity compensation is and describe the different types of equity compensation.
What is Equity Compensation?
Equity compensation is a form of payment that gives employees a stake in the company they work for. Employees are granted equity instead of receiving traditional cash payments. Equity compensation can take different forms, including stock options, restricted stock units, or employee stock purchase plans. By offering equity compensation, companies provide a way for their employees to benefit from the company’s success.
Types of Equity Compensation
There are several types of equity compensation, each with its own unique characteristics. Here are the three most common types:
Stock Options: Stock options are the right to buy a specific number of shares of company stock at a predetermined price. Typically, stock options come with a vesting schedule, meaning employees can’t exercise them immediately. Once an employee has vested in their stock option, they can choose to exercise it at any time during the option’s life.
Restricted Stock Units (RSUs): Restricted stock units are awards of company stock that vest over a set period of time. Once RSUs have vested, the employee owns the shares outright. However, until they vest, the employee has no right to sell or transfer the shares.
Restricted Stock Units (RSUs) are a popular form of equity compensation that, after vesting, results in an employee's receipt of shares of company stock or a cash payout. Similar to a bonus, RSUs can positively affect cash flow but incur taxes that require planning. You may have been (or will be) granted RSUs by your employer during your career. It is important to understand how these interests fit into your overall financial plan.
This checklist will help guide you regarding your RSUs. It covers:
- Key characteristics of RSUs
- Ordinary income tax considerations at vesting
- Capital gains tax considerations at sale
- Company stock and portfolio considerations
Employee Stock Purchase Plans (ESPPs): An ESPP is a program that allows employees to purchase company stock at a discount. Employees can contribute a portion of their salary to the plan, and the company uses the funds to purchase shares on their behalf. Typically, ESPPs have a set period during which employees can enroll and purchase shares.
How Equity Compensation Works
Equity compensation works by offering employees a share of the company’s ownership. The value of the equity can increase or decrease based on the company’s performance. If the company performs well, the value of the equity can increase, providing a valuable benefit to employees. If the company performs poorly, the equity value can decrease, which can be a risk for employees.
One important thing to keep in mind is that equity compensation is not the same as cash compensation. While cash compensation provides immediate value to employees, equity compensation provides potential value that may or may not materialize in the future.
Equity compensation can be a valuable benefit for employees. It allows employees to benefit from the company’s success and can be a powerful motivator. However, it's important to understand the different types of equity compensation and the risks and rewards associated with each. By doing so, you can make an informed decision about whether equity compensation is right for you.
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