What Is an Equity Compensation Plan & How Does It Work?

An equity compensation plan provides employees with an ownership interest in the company, supplementing traditional cash salaries. This non-cash compensation aligns employee financial interests with shareholders. Companies offer these plans to attract and retain talent, motivate long-term performance, and foster shared success, encouraging contributions to growth and profitability.

Understanding Different Types of Equity Compensation

Equity compensation comes in various forms, each with distinct characteristics and tax implications.

Stock Options

Stock options grant an employee the right to purchase company stock at a predetermined price, known as the exercise or strike price, for a specified period. Two main types exist: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs).

ISOs offer potentially favorable tax treatment; the difference between the exercise price and market price at exercise is not subject to ordinary income tax at that time. It may be subject to the Alternative Minimum Tax (AMT), and capital gains tax applies upon the eventual sale of shares, provided holding periods are met. NSOs result in ordinary income tax on the difference between the exercise price and the stock’s fair market value at exercise.

Restricted Stock Units (RSUs)

Restricted Stock Units (RSUs) represent a company’s promise to deliver shares after a specified vesting period. Unlike options, RSUs do not require purchase; they are granted outright once vesting conditions are met. An RSU’s value ties directly to the company stock’s fair market value at vesting.

Upon vesting, the shares’ fair market value is typically treated as ordinary income, subject to income tax withholding. A “restricted period” is the time before full ownership, during which shares cannot be sold or transferred.

Employee Stock Purchase Plans (ESPPs)

Employee Stock Purchase Plans (ESPPs) allow employees to purchase company stock at a discounted price through payroll deductions. These plans involve an “offering period” for contributions and a “purchase period” for stock acquisition. Discounts typically range from 5% to 15% off the stock’s fair market value.

ESPPs can be qualified under Internal Revenue Code Section 423, offering tax advantages similar to ISOs. For qualified ESPPs, the purchase discount is generally taxed as ordinary income when shares are sold, provided holding periods are met. Otherwise, the discount may be taxed at purchase.

Performance Share Units (PSUs)

Performance Share Units (PSUs) are restricted stock units where the number of shares received depends on achieving specific performance metrics. These metrics can include financial targets, operational goals, or stock price performance. PSUs incentivize employees to achieve strategic company objectives, linking rewards to business success.

PSU vesting is contingent on time-based service and meeting performance criteria. If targets are not met, employees may receive fewer shares or none. Like RSUs, the fair market value of shares received at vesting is taxed as ordinary income.

Stock Appreciation Rights (SARs) and Phantom Stock

Stock Appreciation Rights (SARs) and Phantom Stock provide employees with cash or company stock equal to the appreciation in the stock price. Unlike options, SARs require no upfront investment and mirror stock value without granting ownership until settlement.

Phantom stock awards track the value of company shares, with payouts based on value increases. Both SARs and phantom stock are generally settled in cash, though some plans allow for shares. The value received upon settlement is taxed as ordinary income.

Key Concepts and How Equity Plans Operate

Understanding the fundamental concepts of equity compensation plans helps employees navigate their awards and realize value.

Granting

The “grant” is the initial award of equity compensation to an employee. The grant date is when the company formally awards the equity, setting the exercise price for options and beginning the vesting clock. The grant agreement outlines the award’s terms, including units, exercise price (if applicable), and vesting schedule.

Vesting

Vesting is the process by which an employee gains full ownership of their equity compensation. Unvested shares are subject to forfeiture if the employee leaves or fails to meet conditions. Common vesting schedules include “cliff vesting,” where a portion or all vests on a specific date, and “graded vesting,” where a portion vests progressively over years.

Performance-based vesting, often with PSUs, requires achieving specific company or individual targets in addition to a service period. Once vested, employees typically have the right to exercise options or receive shares from RSUs.

Exercise (for Options)

Exercising a stock option means purchasing company stock at the predetermined exercise price, converting the option into shares. The difference between the stock’s fair market value on the exercise date and the exercise price is the “bargain element.” For Non-Qualified Stock Options (NSOs), this bargain element is generally taxed as ordinary income at exercise.

Common exercise methods include cash exercise, where the employee pays with their own funds; cashless exercise, involving selling a portion of newly acquired shares to cover the exercise price and taxes; and net exercise, where the company withholds shares to cover the exercise price and taxes, with the employee receiving the remainder.

Tax Implications at Key Stages

Tax obligations for equity compensation arise at different stages depending on the award type. For RSUs and PSUs, the shares’ fair market value at vesting is typically recognized as ordinary income. This income is subject to federal, state, local, Social Security, and Medicare taxes, and is reported on the employee’s W-2 form. For NSOs, ordinary income tax is triggered at exercise on the difference between the stock’s fair market value and the exercise price.

In contrast, Incentive Stock Options (ISOs) do not generate ordinary income tax at exercise, but the bargain element may be subject to the Alternative Minimum Tax (AMT). When shares acquired from any equity award are sold, any gain or loss is treated as a capital gain or loss. This is calculated as the difference between the sale price and the stock’s cost basis. The cost basis for shares from RSUs or NSOs is generally the fair market value recognized as ordinary income at vesting or exercise.

Fair Market Value (FMV)

Fair Market Value (FMV) in equity compensation is the price an asset would trade for between a willing buyer and seller, both with reasonable knowledge and no compulsion. For publicly traded companies, FMV is typically the closing stock price. For private companies, FMV is determined through periodic valuation processes, often involving independent appraisals.

FMV calculates ordinary income recognized upon RSU vesting or NSO exercise. It also determines the cost basis of shares for capital gains calculations upon sale.

Liquidity Events

A liquidity event is a corporate transaction allowing employees to convert equity compensation into cash or publicly tradable shares. Common events include an Initial Public Offering (IPO), where a private company’s shares are first offered to the public, or an acquisition.

During an IPO, employees may face a “lock-up period,” typically 90 to 180 days, restricting share sales to stabilize the stock price. In an acquisition, employee equity may convert to cash, acquiring company shares, or a combination, based on deal terms.

What to Consider When Receiving Equity Compensation

Receiving equity compensation is a valuable part of a compensation package, requiring attention to grant details to maximize benefits and manage tax obligations.

Review your official plan document and grant agreement. These documents provide definitive terms, including vesting schedules, exercise periods, and forfeiture clauses.

Understand your specific vesting schedule, including any “cliff” period before awards vest and the timeframe for full vesting. Knowing these dates helps in planning.

For stock options, track the expiration date to avoid forfeiture. Options typically have a lifespan of up to 10 years, but this can vary.

Company policies significantly impact equity management. Be aware of “trading windows” for buying or selling stock, any “holding periods,” and implications of leaving the company, as some plans may forfeit unvested or unexercised awards.

Companies generally handle tax withholding at RSU vesting or NSO exercise, often by selling shares to cover estimated tax liability. Understand how this impacts your net shares or cash payout. Your company will issue tax forms, such as a W-2 for ordinary income, and potentially a Form 1099-B if you sold shares.

Be aware of potential dilution. Future equity grants, new financing rounds, or other corporate actions can increase outstanding shares, reducing your percentage of company ownership, though not the number of shares you hold.