Understanding Equity Compensation and Incentive Plans

Equity Compensation | Investment Strategy | Stock Options

 Susan Jones By: Susan Jones

Equity compensation plans come in multiple forms, including stock options, restricted stock units (RSUs), and employee stock purchase plans. Each is designed to give employees a direct stake in the financial success of their companies, and hopefully to provide additional monetary benefits beyond salary.

Sometimes, employers link equity compensation to performance-based incentives designed to motivate employees to work harder and achieve specific goals. In these cases, it helps to understand how incentive plans work — and their potential impact on your equity compensation — to maximize their potential benefits.

How do Equity Compensation and Incentive Plans Work?

The general principle behind equity compensation is to align an employee’s personal interests with the company’s financial goals. If the company grows and is profitable, its stock price is likely to increase and employees can share in that growth. 

In some cases, companies make that link explicit: They make equity compensation dependent on meeting company financial targets or personal job performance goals. For example, a company may make the award based on the company achieving a certain stock price or revenue growth or could make it based on the individual employee’s attainment of a sales goal.   

Whether your equity compensation automatically includes incentives, or you’re offered the choice between two packages with and without incentives, it’s important to understand the details of the incentive component to help you make the most of your award.

Examples of Equity Compensation With and Without Incentives

Understanding how incentives might impact your equity compensation package can help you plan ahead for important decisions about how and when to use those company shares. 

For example, say you join a company that grants you 1,000 non-qualified stock options on a five-year vesting schedule, but they also grant you an additional 500 options if you meet a predetermined sales goal. The first 1,000 shares are subject to a clear vesting schedule, so you can plan ahead for important decisions like when to exercise those shares and how long to hold them, based on the potential tax impact and your financial needs. However, you might not know exactly when you’ll meet the incentive conditions that make your additional shares vest. That means you have more variables to track when developing a plan to use your equity compensation to meet certain financial goals. 

Alternatively, a company may offer you a choice between two incentive packages: A smaller package with no incentives, and a bigger grant that includes incentives. Your decision depends on whether you’d prefer taking the smaller grant, knowing the only restrictions are time-based, or are comfortable taking on the additional risk of performance-based incentives that could lead to a larger reward. While there is no crystal ball to guide you, knowing how likely you are to meet the criteria for the performance based goal, resolving any ambiguities in how the goal is defined and identifying any factors that could impact your achievement of the goal that are outside of your control will help ensure that you make the best decision. You should also consider the potential tax impact a larger grant may have if and when the shares vest. 

How to Ask for Equity

Typically, equity compensation can be negotiated just like salary or other benefits like vacation time. As part of those discussions, you may even be able to negotiate how much of your compensation is subject to incentives. 

Asking for equity can demonstrate your commitment to your employer — but beware of rose-colored glasses. There’s a risk of being overly optimistic about the places we work, but it’s important to be as objective as possible to understand potential upsides and downsides of owning company stock to make sure your needs are met. 

It’s also important to remember that equity compensation is not guaranteed income. For example, falling stock prices may leave options worthless by the time they vest. So before asking for equity, be sure your salary meets your needs for living expenses, debt payments and long-term savings goals.

Including Equity Compensation in Your Financial Planning

To get the most out of equity compensation, you have to include it in your long-term financial planning. For example, make it a practice to understand equity compensation vesting schedules for income and tax planning. And if you are thinking about leaving your employer, remember that you won’t receive any equity compensation that hasn’t yet vested when you quit. Also, remember that some circumstances are outside of your control, so be sure to understand how your equity compensation is impacted if you become disabled and unable to work or if the company is acquired so that you can plan accordingly.

A financial advisor can help you develop strategies for managing taxes in years when your income receives a boost from exercised options. Your advisor may also suggest how to use other benefits to offset the impact of equity awards. For example, if your employer offers you access to a non-qualified deferred compensation (NQDC) plan, you have the option to defer income into the plan to lower your federal and state income tax liability. NQDC holdings can be invested and grow tax-deferred much like funds inside a 401(k), but they aren’t risk-free. The plans are what is known as an unfunded and unsecured company obligation, meaning if your company falls on hard times, you could lose some or all of the pay you deferred into the account. Also, while a NQDC contribution can lower taxes in the year of deferral, distributions can create an income “bunching” effect that ultimately increases the overall tax you pay on those earnings, so it’s important to weigh the current benefit against the potential pitfalls later on.

Finally, remember that a large position in any single stock adds risk to a portfolio. If incentives increase the possibility that you will hold a larger stake in your company’s stock, consider making a plan to divest company shares and create a more diversified portfolio. 

Each form of equity compensation has its own set of rules and tax implications. To learn more about these rules see Plancorp’s e-book “How to Make the Most of Equity Compensation.”

New call-to-action

Disclosure:

This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.

Plancorp is a registered investment advisor with the Securities and Exchange Commission ("SEC") and only transacts business in states where it is properly registered or is excluded or exempted from registration requirements. SEC registration does not imply a certain level of skill or training. Please refer to our Form ADV Part 2A disclosure brochure and our Form CRS for additional information regarding the qualifications and business practices of Plancorp.

Related Posts

For over twenty years, Susan has passionately provided wealth management services to individuals, families, fiduciaries, private foundations and their related entities with a focus on sophisticated income, gift and estate tax consulting and compliance, proactive executive compensation planning and succession planning. Susan understands the many facets involved in creating a successful multi-generational family legacy and uses a forward-looking approach to help clients grow and preserve assets, reduce taxes and realize both their financial and non-financial goals. Susan’s experience includes practicing law in the tax and estate planning. More »