Stock Compensation is one way that employers compensate their employees in lieu of cash. Read below for information on four commonly-used stock compensation strategies.
Employee Stock Compensation:
Stock compensation is a strategy employed by corporations to reward employees in lieu of cash and is oftentimes utilized as a recruiting tool to enhance an employee’s total compensation package. Employee stock compensation is often subject to a vesting period before the employee can collect and sell their option. In some cases, a ‘cliff’ schedule is used where employees become fully vested in all of the options issued to them after three years. In a ‘graded’ vesting schedule, starting in year two, employees become invested in one-fifth of the options granted each year. The employee is then fully vested in all of the options issued to them in the sixth year of the grant.
There are several types of employee stock compensation, namely Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs or NSOs). Incentive Stock Options or “Statutory” or “Qualified” Stock Options grant employees the right to buy shares at a discounted price on a future date. ISOs must be held for more than one year from the date of exercise and require a vesting period of at least two years from the time of the grant to qualify for more favorable tax treatment. In doing so, any profits will be labeled as capital gains and taxed as such rather than as earned income. For ISOs specifically, the offering period is 10 years, meaning after 10 years the options expire. Non-Qualified Stock Options give employees the right to purchase a set number of shares at a preset price within a designated time frame. This particular form of employee stock compensation is more common than ISOs but is similarly utilized as an alternative to cash compensation. Unlike ISOs, NSOs are typically taxed as ordinary income, which one will pay on the difference between the grant price and the price at which you exercise the option.
Restricted Stock Units (RSUs) are another form of compensation issued by employers through a vesting plan and distribution schedule contingent on achieving required performance milestones or upon achieving a specified tenure. RSUs incentivize employees to stay with a company long term and help it grow. They have no tangible value until vesting is complete. Once complete, RSUs are considered income and a portion of the shares is withheld to pay income taxes. When an employee holds their shares until they receive the full, vested allocation, and assuming their company’s stock rises, the employee will receive the difference in the capital gain and the value for shares withheld for income taxes plus the amount due in capital gains taxes.
Employee Stock Purchase Plans (ESPPs) are company-run programs where participating employees contribute through payroll deductions which build up between the offering date and purchase date. At the purchase date, the company uses the accumulated funds to purchase stock on behalf of the employees. In some cases, the discount rate on company shares can be as much as 15% lower than the market price. Also, some ESPPs may have a ‘look back’ provision which allows purchases at a historical price such as the offering date or purchase date.
Lastly, Performance Shares are allocations of company stock to managers and executives if certain company performance criteria are met. Often, this criterion is earnings per share (EPS), return on equity (ROE), total return of the company’s stock in relation to an index, cash flow from operating activities or a combination of several metrics on the company’s overall health and trajectory over a set period of time. Typically, these performance periods represent a multi-year horizon.
Disclosures
Investment advice offered through Shepherd Financial Partners, LLC, a registered investment advisor. Registration as an investment advisor does not imply any level of skill or training.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
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