In the past several years, the use of equity compensation has grown in some industries. This is especially true in tech, where stocks performed impressively through the end of 2021. Companies offer equity compensation as a way to attract and retain top talent, align the interests of key employees with those of the company, and foster more of an ownership mentality with their workforce.
When used appropriately, equity compensation can also be a powerful way for employees to build substantial wealth, potentially playing a key role in one’s ability to achieve and maintain long-term financial independence. However, equity compensation plans can be very complex. If you’re feeling overwhelmed, you’re not alone.
3 Different Types of Employee Stock Options
Before digging into a few planning strategies, let’s start by exploring three of the most common types of equity compensation: restricted stock, employee stock purchase plans, and stock options.
Restricted stock comes in many flavors, including restricted stock units, restricted stock awards, and performance shares. At a high level, it is easiest to think of restricted stock as a cash bonus. But instead of receiving cash, you are awarded shares of company stock that you’ll receive in the future when certain conditions are met. These conditions are most often time-based, but they can also be tied to personal performance, company performance, stock performance, and/or a future transaction, such as an initial public offering, merger, or acquisition.
Employee stock purchase plans allow employees to buy company stock at a discounted price relative to fair market value at the time of purchase. Although ESPPs are often considered a form of equity compensation, they are not directly tied to employee compensation. Instead, think of an ESPP as more of a “perk” that is only accessible to company employees. Participation is almost always open to all employees and is completely voluntary. Contributions to ESPPs are made through payroll. After a specified period of time has passed (usually three to six months), the cash accumulated is used to buy company stock at a discount using a formula that can vary drastically from one plan to another. There is no tax due upon purchase, but the taxation of ESPP stock once it is sold is very complex; it’s contingent on a number of rules related to holding periods and performance.
Stock options are quite different from restricted stock and ESPPs. Instead of owning shares of company stock outright, stock options give employees the right to buy company stock at a predetermined price, subject to a vesting schedule and expiration date. Company stock is actually acquired when you voluntarily decide to “exercise” your stock option. Although unexercised stock options can offer a great deal of leveraged upside if your company stock does well, they can also be worthless if the stock price never exceeds what it was on the date the options were granted to you.
What Are Some Equity Compensation Strategies for Building Net Worth?
Equity compensation is complicated, but that doesn’t mean you have to close your eyes, take action, and hope for the best. There are a number of solid principles to adhere to as you make decisions regarding your equity compensation. Here are some key equity compensation strategies to consider.
First, it’s important to do your homework. Take the time to understand what you have, how it works, and what current and future decisions need to be made. Read through your company’s stock plan document, each of the grant agreements you receive, and any company-provided resources made available to employees. Don’t be afraid to reach out to human resources with follow-up questions.
Keep your concentration risk in check. Holding too much of any one stock position is a risk that can lead to major financial setbacks. This is especially true when the large stock position you hold is also in the company you rely on for income. Getting laid off is a challenging situation for anybody to be in. However, it is especially tough when the company stock position you might have otherwise used to help bridge the gap to your next job is also worth substantially less than it was before.
Know the rules of the game, especially when it comes to taxes. Learn the ropes on different holding period requirements that may apply in order to receive more favorable tax treatment. If you have incentive stock options, make it a priority to learn how the Alternative Minimum Tax works, when it applies, and how to plan accordingly. Do what makes the most sense for your situation in the most tax-efficient way possible, in that order.
Invest with a plan. Here are some questions to ask yourself about equity compensation: What goals and priorities are you planning to fund with company stock? How much will you need for each of those, and by when? Given your willingness and ability to take risk, are you holding the right amount of company stocks? What should you do with shares that vest in the future: hold, sell and diversify, or sell and move to cash? How would a substantial drop in the value of company stock impact your ability to accomplish the things that matter most to you?
Finally, avoid the trap of thinking you can always sell for more later. Just because your company stock has been worth more in the past does not necessarily mean it will get there again any time soon or, perhaps, at all. Interest rates, economic recessions, new laws and regulations, geopolitical events, and many other factors can often drive stock performance — all of which are outside of your control.
There is much to learn and consider when it comes to equity compensation, and it is easy to let emotions sway your thinking. A disciplined, thoughtful, and proactive approach to managing company stock can go a long way toward building lasting wealth and achieving financial independence.
About the Guest Post Author:
Derek Jess is a senior wealth manager and shareholder at Plancorp (https://www.plancorp.com), a full-service wealth management company serving families in 44 states. With specializations in financial planning for employees with equity-based and deferred compensation plans, he helps high-income clients with complex needs navigate through all stages of life.