What Is Equity Compensation?
Equity compensation provides employees with an ownership stake in the company, aligning their financial interests with those of shareholders. Once reserved primarily for executives, equity awards are now widely used across all levels of the organization, particularly in technology, biotechnology, and startup companies. For SHRM exam candidates, understanding the types of equity vehicles, their tax implications, and their strategic applications is important.
Types of Equity Compensation
Stock Options
Stock options grant employees the right to purchase company shares at a fixed price (the exercise or strike price) for a specified period, usually up to 10 years. The employee profits when the stock price rises above the exercise price (this difference is called the "spread").
Incentive Stock Options (ISOs)
- Available only to employees (not consultants or board members)
- Receive favorable tax treatment if holding period requirements are met: no ordinary income tax at exercise, and gains are taxed at long-term capital gains rates upon qualifying disposition
- Subject to annual limits on the value of shares that can become exercisable in a given year ($100,000 based on fair market value at grant)
- May trigger alternative minimum tax (AMT) at exercise
Non-Qualified Stock Options (NQSOs)
- Available to employees, consultants, directors, and other service providers
- No favorable tax treatment: the spread at exercise is taxed as ordinary income and subject to employment taxes
- More flexible than ISOs with no annual limits or holding period requirements for tax treatment
- The employer receives a tax deduction equal to the income recognized by the employee at exercise
Restricted Stock Units (RSUs)
RSUs are promises to deliver company shares (or their cash equivalent) at a future date, typically upon satisfaction of a vesting schedule. Unlike stock options, RSUs have value even if the stock price declines from the grant date, as long as the shares retain some value. RSUs are taxed as ordinary income at vesting based on the fair market value of the shares delivered.
Restricted Stock Awards (RSAs)
RSAs are actual shares granted to employees that are subject to vesting restrictions. Unlike RSUs, the employee holds the shares from the grant date and may receive dividends and vote the shares. Employees can file a Section 83(b) election within 30 days of grant to recognize income at the grant date value, potentially reducing their total tax burden if the stock appreciates.
Performance Share Units (PSUs)
PSUs are similar to RSUs but vest based on achieving specific performance conditions rather than (or in addition to) time-based service. Common performance metrics include revenue growth, earnings per share, return on equity, or relative total shareholder return. PSUs are particularly popular in executive compensation because they directly link payouts to company performance.
Employee Stock Purchase Plans (ESPPs)
ESPPs allow employees to purchase company stock at a discount, typically 5 to 15 percent below market price. Qualifying (Section 423) plans offer favorable tax treatment if holding period requirements are met. ESPPs are widely used as a broad-based equity vehicle because they are simple to understand and available to most employees.
Vesting Schedules
Equity awards typically vest over time to promote retention. Common vesting structures include the following.
- Cliff vesting: The entire award vests at once after a specified period (for example, 100 percent after one year)
- Graded vesting: A portion of the award vests at regular intervals (for example, 25 percent per year over four years)
- Performance vesting: Vesting is contingent upon achieving specified goals
Strategic Considerations
When designing equity compensation programs, organizations must consider dilution impact on existing shareholders, accounting expense under ASC 718, cash flow implications (particularly for repurchases), the competitive landscape for talent, and the desired balance between retention and performance motivation. The choice between options, RSUs, and other vehicles depends on company maturity, stock price volatility, employee preferences, and tax considerations for both the company and participants.
SHRM Exam Tips
Focus on the differences between ISOs and NQSOs, the characteristics of RSUs versus RSAs, vesting schedule types, and ESPP provisions. Understand the basic tax treatment of each vehicle and when each type is most appropriate. Questions may require you to recommend an equity strategy for a specific organizational scenario.