Equity compensation is a form of non-cash payment for services that gives the employee an ownership interest in the company. Long the domain of only the C-suite and key employees, grants of restricted stock and incentive options are increasingly used to motivate and retain younger and mid-level employees of the leanest startups to the largest public and private enterprises.  But while these programs offer the potential for significant wealth accumulation, they also increase the level of risk the employee and her family are exposed to should the company take a turn for the worse.

Not only might a significant portion of your wealth be tied up in the value of a single stock (i.e. a lack of diversification), but your family’s income is also dependent on that same company. And if you live in a town or city whose local economy is dominated by a particular company or industry, the value of your home and other investments in the local community may also be at risk! Ask yourself, what would be the impact on my family if the value of these shares went to zero?  How would my life change meaningfully if they went to the moon? 

Beyond the rational weighing of risk and reward, there are many behavioral and social factors at work. As an insider, you may feel like you have a better handle on the workings of your company and a strong belief in its growth or mission. And while this may be true, remember there are also forces at play that are outside of your purview. It can be easy to get caught up in groupthink, especially when you’re investing so much of your time, talents, and energy into the firm already. Even if you have decided to diversify, there can be pressures not to sell. Selling your shares may be viewed by your boss or colleagues as showing a lack of commitment or belief. FOMO is also a hugely common factor (what if I sell right before it skyrockets?), as is tax aversion (I would sell, but I don't want to pay the taxes). Both of these phenomena have led too many to hold onto too much stock for too long. 

When deciding whether to keep or divest awarded stock, ask yourself, “If I had the cash instead, what would I do? Would I buy more of the stock, buy more diversified investments, or would I use it for something else entirely?” How you answer this question should guide what you do with your equity compensation instead of letting socioemotional forces drive your decision-making. While tax considerations should be included in your planning, the saying, “Don’t let the tax tail wag the dog,” is apt. 

There’s no question that ownership is the primary wealth generator in our capitalist system, and equity compensation can have many benefits to both the individual and the firm. Yet, because of the risks and complexities involved, and the outsized impact it can have on your financial situation (for better or for worse), it’s essential to understand the nuances and manage behavioral biases associated with equity comp. Armed with this knowledge and an understanding of how stock compensation fits into your overall financial plan, you can take advantage of these opportunities from a position of clarity and security. 

What follows is an overview of the most common types of equity compensation (RSUs, ESPP, and stock options) and the terms and considerations that are unique to each. While the tax laws and regulations may seem complicated (and they are!), always be sure to bring it back to the guiding questions we touched on already. A good financial advisor can help you think through the details without losing sight of the big picture.

Restricted Stock Units (RSUs) 

RSUs are one of the simplest and most common forms of equity compensation. They are essentially a promise of a given quantity of stock at a future date. The recipient receives a “grant” that details the amount of time or performance milestones attached to the future receipt of the shares. Upon vesting, the company will issue those shares to the employee, less any withholding for taxes. Once the shares are vested and taxes are accounted for, you own the company stock just as if you had purchased it on your own. If you sell immediately, there are no additional taxes because there is no capital gain or loss.

The key question to ask yourself when deciding whether to hold the shares or sell them immediately is this: “If I got a cash bonus instead, would I use it to buy shares in my company?” If not, that’s a good indication that you should just cash out now, or as the Steve Miller Band put it, “Go ahead, take the money and run!” 

Click here for strategies for managing RSUs, tax treatment, and a helpful checklist.

Employee Stock Purchase Plans (ESPP)

Employee Stock Purchase Plans give participants the chance to buy company stock at a discount of up to 15% and are funded with paycheck withholdings. These plans are often designed to give you the added option to purchase the shares at the lower of either the starting price or ending price of the stock during the offering period, in addition to receiving the 15% discount. Not a bad deal! 

You’ll need to enroll in the plan ahead of time and elect a flat dollar amount or a percentage to be withheld from your paycheck. Tax law limits the maximum fair market value of stock that can be purchased using ESPPs to $25,000 and employers will typically limit the percentage of your salary that can be withheld for the ESPP to a maximum of 15%. Because of these limitations, ESPPs will not allow you to accumulate very large amounts of stock; however, through regular participation in the ESPP coupled with the immediate sale of those shares, you receive a virtually risk-free bonus. Rinse and repeat!

Click here for more details on how ESPPs are taxed and a helpful flowchart.

Stock Options (ISOs & NSOs)

Stock options give the recipient the right, but not the obligation, to purchase shares of company stock at a predetermined price for a certain period. If the price of the company stock increases, the option holder will be able to purchase shares at a lower price than the current market price once the options vest (or the plan may allow for early exercise). Stock options have a lot of financial leverage, meaning if the stock goes up a lot you can receive a huge amount of value. From the recipient's perspective, ISOs and NSOs differ only in their tax treatment, with ISOs being eligible for more favorable capital gains rates if certain restrictive conditions are met (but also subject to AMT). 

Click here for more detailed information on ISOs and NSOs and a checklist of major planning considerations

Other Forms of Equity Comp

There are many other forms that equity compensation can take, each with its nuances and planning opportunities, but the same general considerations hold. Here’s a non-exhaustive list of other forms of equity compensation:

• Stock grants

• Restricted stock awards (RSAs)

• Stock appreciation rights (SARs)

• Phantom stock

• Junior class shares

• Employee Stock Ownership Plans (ESOPs) 

• Stock Bonus Plans within a Qualified Profit Sharing Plan (i.e. retirement account)