Stock Options 101: The Three Most Common Types of Equity Compensation

When stepping into roles at startups, tech firms, late-stage private companies, or even publicly traded companies, compensation packages likely extend beyond mere salary and bonuses. A particularly influential yet complex form of compensation is equity compensation, also known as stock options. Stock options grant a stake in a company’s future and can substantially impact your overall compensation and income.

Understanding the nuances of equity compensation can be pivotal in capitalizing on its potential. The purpose of this article is to delve into the three of the most prevalent types of equity compensation—Restricted Stock Units (RSU’s), Incentive Stock Options (ISOs), and Non-Qualified Stock Options (NSOs). There are others, such as Employee Stock Purchase Plans (ESPP), Employee Stock Ownership Plans (ESOP), Stock Appreciation Right (SAR), or Performance Share Units (PSU). For this article though, we will focus on these RSU’s, ISO’s, and NSO’s. We’ll dissect each type to empower you to navigate your compensation plan with confidence.

What is Equity Compensation?

Equity compensation involves company-provided ownership or the right to acquire ownership through stock. It is designed to align your personal interests with the company’s. In a way, they are “golden handcuffs.” If the business flourishes, so does the value of your equity and personal net worth.

The Three Most Common Types of Equity Compensation

1. Restricted Stock Units (RSU’s)
2. Incentive Stock Options (ISO’s)
3. Non-Qualified Stock Options (NSO’s)

Let’s explore each type, focusing on their structure, tax implications, and potential risks.

1. Restricted Stock Units (RSU’s)

RSU’s are the simplest form of equity compensation. Here’s how they work:

• Structure: No purchase is required. You are granted a number of company shares that vest over time. Upon vesting, the shares become yours. The value of the shares you own depends on the value of the company stock at each vest date.
  • Example: ABC Company grants you 900 shares of restricted stock with a vest schedule over 3 years with one-third vesting each year. 300 shares vest after year 1 at a price of $20 per share, 300 shares after year 2 at a price of $25 per share, and 300 shares after year 3 at a price of $30 per share. The grand total of this 3-year vest equals $22,500.
• Taxation: At vesting, the value of the shares is taxed as ordinary income, using the fair market value at the vesting date. Determining this fair market value differs between public and private companies. Public company fair market value is usually the closing trading price of the stock on the vest date. Private company shares rely on an annual 409A valuation.
  • Example: 300 restricted stock shares vest at $20 per share. The ordinary income credited to you equals $6,000.

2. Incentive Stock Options (ISO’s)

ISO’s are a more complex, unique type of stock option.

• Structure: ISO’s are offered to employees and become most valuable with significant company growth prospects. With an ISO, it grants the right to purchase (exercising) shares at a fixed price (strike price). The stated exercise price must be greater than the fair market value of the stock at the grant date.
  • Example: ABC Company grants an ISO to you with a strike price of $10. The grant date fair market value is $5. You may purchase (exercise) the NSO when the stock has eclipsed $10 per share. If the stock reaches $20 per share, you may exercise and purchase the share for $10.
• Taxation: ISO’s have strict IRS requirements but receive favorable tax treatment if these requirements are followed. Upon exercise, you must hold the shares for one-year post-exercise and two years from the grant date. If you sell the ISO shares one-year post-exercise and two years from the grant date, you qualify for long-term capital gains tax rates. However, be wary of the Alternative Minimum Tax (AMT) with ISO’s because the spread (market value – strike price) is an AMT preference item. I discuss AMT planning with ISO’s more in a later article.
  • Example: Using the above scenario, you purchase the ISO share for $10 when the stock is trading at $20 per share. You hold your ISO share for over a year after exercising and two years from the grant date. Now, you sell your ISO share at $30. You will receive long-term capital gain treatment on the $20 profit ($30 – $10).

3. Non-Qualified Stock Options (NSO’s)

NSO’s are also complex, but more widespread than ISO’s.

• Structure: NSO’s are commonly awarded to employees, directors, contractors, or board members. There is flexibility in design. Similar to ISO’s, they offer purchase rights at a set strike price. Exercise these options when “in the money” (market value exceeds the strike price).
  • Example: ABC Company grants an NSO to you with a strike price of $20. You will want to consider purchasing (exercise) the NSO when the stock has eclipsed $20 per share.
• Taxation: NSO’s do not have the same tax treatment as ISO’s. They are not subject to possible AMT. However, upon exercise of purchasing the NSO shares, the difference between market and strike prices is taxed as ordinary income. Further, any gains realized post-exercise are taxed as capital gains, short-term or long-term depending on holding period.
  • Using the above scenario, you purchase the NSO share for $20 when the stock is trading at $40 per share. You realize ordinary income on the spread ($40 – $20). You will pay ordinary income tax on $20. You hold your NSO share for over a year after exercising. Now, you sell your ISO share at $60. You will receive long-term capital gain treatment on the $20 profit ($60 – $40).

I dive more into NSO’s and the planning considerations in a later article.

Important Considerations

Vesting Schedules

Equity vesting schedules, whether they are cliff or graded, vary widely:

• Cliff Vesting: No equity vests until completing a certain period, like a year or two years. All equity compensation granted vests immediately after the cliff.
• Graded Vesting: Ongoing vesting in either quarterly, semi-annual, or annual increments after a designated blackout period.

Vesting schedules impact when equity becomes yours. Knowing when the stock options become yours should enable you to make informed financial decisions about the right approach for exercising and selling.

Key Questions to Ask:

When you receive an equity compensation offer with stock options, consider asking:

1. What type of equity granted?
2. What is the vesting schedule?
3. For ISO’s and NSO’s options, what is the strike price?
4. What is the current company value and growth prospects?
5. How many shares are granted, and what company percent do they represent?
6. What happens to my stock options if I leave the company?
7. Have I coordinated my equity compensation into my overall financial, tax and investment strategy?

Final Thoughts

Stock options are complex, yet it can be a magnifying wealth driver. Integrating equity compensation within a broader financial, tax, and asset allocation strategy can turn this asset into a pathway to long-term wealth. However, do it correctly. Understanding the mechanics, tax implications, and connection with your personal financial goals is crucial. Leverage insights and advice from a Certified Financial Planner like me who specializes in coordinating all the nuances surrounding stock options.  It’s worth the time to navigate these complex instruments appropriately.

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