What Are Equity Grants & How Do They Work?

Equity grants are a form of non-cash compensation provided by companies to employees, and sometimes to consultants or advisors. Their purpose is to align the interests of the recipient with the long-term success and growth of the company. These grants give individuals a stake in the company’s future value, moving beyond traditional salaries or bonuses. By offering ownership, companies aim to incentivize dedication, foster a sense of shared purpose, and encourage contributions that enhance overall company performance. This compensation method is particularly prevalent in growth-oriented companies, where cash resources might be limited but the potential for future value creation is significant.

Core Components of Equity Grants

The “grant date” marks the official day a company formally awards an equity grant to an individual. This date often serves as the starting point for eligibility and value.

Following the grant date, a “vesting schedule” dictates when the recipient gains full ownership or the right to realize the value of their equity. The “vesting period” is the total duration over which the equity grant becomes fully owned. A common vesting period is four years, often with a one-year “cliff.” Under a cliff vesting schedule, no equity vests until a specific period, such as one year, has passed. If an employee leaves before this cliff, they typically forfeit all unvested equity.

Alternatively, a “graded vesting” schedule allows portions of the equity to vest incrementally over time, such as monthly or quarterly installments after the initial cliff. For example, after a one-year cliff, 25% of the equity might vest, with the remaining portion vesting evenly over the next three years. For stock options, an “exercise price,” also known as a “strike price,” is a predetermined cost at which the recipient can purchase shares once they have vested. This price is usually set at the market value of the stock on the grant date.

The vesting process ensures that the compensation is earned over time, encouraging long-term commitment. Unvested equity typically cannot be exercised or sold and may be forfeited if the employee departs the company before the vesting conditions are met.

Common Types of Equity Grants

Stock options provide the recipient with the right, but not the obligation, to purchase a company’s stock at a predetermined “exercise price” within a specified timeframe. These are typically valued if the company’s stock price rises above the exercise price.

There are two primary types of stock options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). ISOs are a special type of stock option granted exclusively to employees and offer potentially favorable tax treatment. The grant, vesting, and exercise process for ISOs involves specific rules. NSOs, by contrast, can be granted to a broader group, including employees, consultants, and even board members, and offer more flexibility without the strict IRS requirements of ISOs. When NSOs vest, the recipient gains the right to purchase shares at the exercise price, and the difference between the exercise price and the market value at the time of exercise is generally taxed as ordinary income.

Restricted Stock Units (RSUs) represent a promise from the company to deliver actual shares of stock or their cash equivalent to the recipient once specific vesting conditions are met. Unlike stock options, RSUs do not require the recipient to purchase the shares; they are simply converted into actual shares upon vesting. The value of RSUs is typically taxed as ordinary income when they vest.

Performance Share Units (PSUs) are a variation of RSUs where vesting is contingent not just on time, but also on the achievement of specific performance targets. These targets can include financial metrics like revenue growth or profitability, or operational goals. If the company or individual meets the predefined performance criteria, the PSUs vest and convert into shares, similar to RSUs. PSUs align employee incentives directly with company performance goals, ensuring that equity rewards are tied to measurable success.

Employee Stock Purchase Plans (ESPPs) offer employees a mechanism to purchase company stock at a discount, typically through payroll deductions. The discount offered can be as much as 15% off the market price of the stock. Employees contribute funds over an “offering period,” and at the end of this period, the accumulated funds are used to buy shares at the discounted rate, often based on the lower of the stock price at the beginning or end of the offering period. ESPPs provide an immediate, built-in gain due to the discount, making them a relatively low-risk way for employees to acquire company stock.

Understanding Taxation of Equity Grants

For Non-Qualified Stock Options (NSOs), there is no tax event at the grant date. When NSOs are exercised, the difference between the fair market value of the stock at exercise and the exercise price is taxed as ordinary income. This amount is reported as wages on an employee’s W-2 and is subject to income tax, as well as Social Security and Medicare taxes. Any subsequent gain or loss from the sale of the shares, calculated from the market value at exercise, is treated as a capital gain or loss.

Incentive Stock Options (ISOs) offer potentially more favorable tax treatment. There is generally no regular income tax due at the time of grant or exercise. However, the difference between the exercise price and the fair market value at exercise is considered a preference item for the Alternative Minimum Tax (AMT), which could trigger a tax liability for higher-income individuals. The primary tax event for ISOs occurs when the shares acquired through exercise are sold. If the sale is a “qualified disposition” (shares held for at least two years from the grant date and one year from the exercise date), the entire profit is taxed at the lower long-term capital gains rates. If these holding periods are not met, it results in a “disqualifying disposition.” In such a case, the “bargain element” (difference between the fair market value at exercise and the exercise price) is taxed as ordinary income, and any additional gain is taxed as a capital gain or loss.

Restricted Stock Units (RSUs) and Performance Share Units (PSUs) are taxed similarly. There is no tax at the grant date. Upon vesting, the fair market value of the shares received is taxed as ordinary income. This income is subject to federal income tax, Social Security, and Medicare taxes, and employers typically withhold a portion of the shares to cover these taxes. If the shares are held after vesting, any subsequent appreciation or depreciation is subject to capital gains or losses when the shares are eventually sold. The holding period for capital gains starts from the vesting date.

Employee Stock Purchase Plans (ESPPs) also have specific tax rules. Generally, no tax is due at the time of purchase, even if shares are bought at a discount. The tax event occurs when the shares are sold. If the sale is a “qualified disposition” (shares held for at least two years from the offering date and one year from the purchase date), the discount received is taxed as ordinary income, and any additional gain is taxed at long-term capital gains rates. For a “disqualifying disposition” (shares sold before meeting the holding periods), the difference between the fair market value at the purchase date and the discounted purchase price is taxed as ordinary income. Any further gain or loss is treated as a capital gain or loss, depending on the holding period from the purchase date.