Everything you need to know about equity compensation

If you’ve been offered equity as part of a compensation package, what you’ve actually been offered is shares of stock, or options to buy shares of stock. Equity compensation involves offering employees equity in a company (stock ownership) as payment. For startups, which often have limited cash flow, equity is often offered as an employee benefit to supplement cash compensation.

Employers typically don’t award stock grants or options on your first day at the company; Instead, you’ll typically receive your equity compensation over a set period of time known as a vesting schedule.

On a typical four-year vesting schedule with a one-year cliff, you’ll receive 25% of your shares after one year, and the remainder will vest monthly. (The cliff is the amount of time you have to wait before vesting can begin, and is designed to keep new hires from leaving a company early.)

While most compensation involves a vesting period, there are several different types of equity compensation, and each works a little differently. 

The most common type of equity compensation for small, private companies (startups) comes in the form of stock options. A stock option is a contract that gives you the right to purchase a certain number of shares of stock at a discounted rate (called the exercise price) during a set timeframe known as the exercise window. When your shares vest, you’ll have the option of buying, or exercising, the stock. 

Incentive stock options (ISOs), also known as statutory stock options, are not taxed until you sell the stock, as long as you hold the stocks for one year after exercising (buying) your options, and two years after they were granted. When you sell the stock, you’ll pay capital gains tax rates. (If you don’t sell your ISOs the same year that you exercise them, you may activate the alternative minimum tax, which is a way of calculating tax for high earners.) 

Nonstatutory or nonqualified stock options (NSOs) are taxed at the income tax rate when exercised, whether you decide to hold the stock or sell it immediately. If you hold onto the stock for one year, you’ll pay capital gains tax when you sell.

Restricted stock awards are grants of stock that vest on a time- and/or performance-based vesting schedule. This means that the company will give you the stock outright once you have met certain requirements. (This is fairly uncommon.) Restricted stock awards are generally  taxed as income when your shares vest.

Restricted stock units (RSUs) represent restricted stock shares (or cash) that your company will give you at a future date known as the settlement date. RSUs are a relatively new type of equity compensation that has become the go-to for larger companies (both public and private). 

There are pros and cons to RSUs. On the one hand, RSUs don't require you to buy the shares, so you don't have to spend money in order to own the stock. On the other hand, RSUs are taxed at the time of vesting, so if you’re an employee at a company that hasn't gone public, you may have to pay tax on shares that you can't yet sell.

Employee stock purchase plans (ESPP) allow you to purchase stock at a discounted rate, usually through payroll deductions. Your company will use the accumulated funds to buy stock for every participating employee. The mechanics vary by plan, but ESPPs are generally taxed when the stock is sold. You’ll pay income taxes over the discount, and capital gains tax over the rest.

When it comes to comparing compensation offers, there are a couple of ways to think about the value of the equity you’re awarded. A higher number of shares doesn’t necessarily mean more equity. Your personal equity in the company relates to the number of shares you have, and the total number of shares of the company’s stock in existence. 

To figure out what percent of the company you own, ask your employer for the number of “fully diluted” shares, which includes stock that has not been issued yet, but could be issued in the future. You can then use the valuation of the company (trickier to determine for private companies than public companies) to get an idea of the worth of your equity compensation.

You’ll also want to take into account the vesting schedule. You likely won’t be able to liquidate (sell) your shares right away, so there is an element of risk involved in accepting equity compensation. Think about how long you plan to stay at the company, and your own predictions for the company’s success. As a general rule, make sure you don’t only invest in your company—keeping your net worth in a range of investments is the best way to protect yourself from losses.

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