4 Potential Equity Compensation Problems and How to Solve Them
Non-cash compensation might not seem like a great deal to you as an employee – but depending on the type, it can actually increase your net worth significantly over time. Stock compensation is a type of “non-cash” composition that your business can provide, but that doesn’t mean it has no value.
Equity compensation provides you with a share of equity in your business, which allows you to enjoy upward growth potential. If the company as a whole is doing well, then you, as the owner of a portion of the equity in the company, do the same by increasing the share price which can help increase the value of your portfolio. investment and generate a profit in the event of a sale.
Common forms of equity provided to employees in compensation programs include:
- Incentive Stock Options (ISO)
- Restricted shares or restricted share units (RSUs)
- Unqualified stock options (NQSO)
- Ability to participate in employee stock purchase plans (ESPP)
You can also see stocks such as ghost stocks or performance units. Every business is different, so it’s important to understand what kind of stock compensation you get if it’s offered to you.
Equity compensation can boost the overall value of your income and investments, but that doesn’t mean they’re all benefits and no risk. There are serious issues that can arise if you don’t manage this part of your pay well.
Here are four potential problem areas to watch out for and what to do about them:
1. Stock-based compensation introduces a lot of complexity into your financial plan
While RSUs and ISOs can both be types of equity compensation, they are all very different. Even ISOs and NQSOs, while sounding similar, behave differently, especially when it comes to the tax implications of receiving, exercising, and holding shares.
Each type of capital has its own parameters and nomenclature that you should know. Failure to fully understand the nuances of the specific type of capital you might have access to can lead to serious issues in the future, including massive bills at tax time or missed opportunities if expiration dates go. and come.
You should refer to your plan document to understand exactly what type of stock compensation you have and all the rules for managing it. Some important terms and conditions to watch out for may include:
- Award and vesting dates
- Strike price
- Exercise date
- Trading windows
- Blackout periods
- Provisions for feedback and discounts (for ESPPs)
You may also want to discuss tax planning considerations with a financial advisor and a CPA. All stock-based compensation is not taxed in the same way, or even at the same time. ISOs, for example, may not be taxed when your options are granted to you … but RSUs are taxable when they vest and become yours.
2. Equity compensation is not always easily accessible
Almost all types of compensation awards are subject to a vesting period. This means that equity compensation could be part of your compensation package from day one… but until that capital is actually earned, it’s just a promise your business makes at a future date.
The vesting periods are often one to two years. During this time, things like stock options or RSUs are not technically yours and you cannot sell them or rely on a particular stock because the stock price can change drastically over time. during the period.
Even when your stocks or options do eventually vest, your ability to act on them may be limited. Many come with window trading stipulations, which allow you to buy or sell stocks once you own them.
Vesting schedules or holding periods are not inherently bad. They just need to be factored into your planning process.
3. Have equity, will pay tax
There is no free lunch, especially on something of considerable value. The IRS will certainly want a share of any appreciation or profits from your stock compensation, and you need to know exactly how your specific type of stock will be taxed – and when.
Talking to a tax advisor about your equity compensation can help you plan appropriately so you don’t get caught off guard when filing your taxes and find that you should have set aside more to cover the obligation. created by a sale of shares.
Here are some things to consider:
- What is considered a taxable event, based on the stock compensation available to me?
- Will my taxes be important enough to guide the equity compensation decisions I make, or are other priorities more important?
- Will I make a qualifying or disqualifying provision for the options I exercise? What is the best course of action in the context of my overall financial plan?
- When will I be subject to alternative minimum tax and how can I plan appropriately for it?
Finally, you may think you are covered from a tax standpoint if taxes are automatically withheld before the shares are awarded to you. This can happen with the acquisition of RSUs, for example. Your business can withhold up to 22% of the value of a stock to pay taxes, which may be enough… or well below what you actually owe.
Your actual tax rate could be more than 30% because RSUs are taxed like ordinary income. If you are already well paid from your normal W-2 salary, the value of the RSUs earned may push you into higher tax brackets, which will increase the amount you owe.
4. Equity compensation can create concentration in your investment portfolio
It is very easy to acquire a concentrated position in the stocks of your company if you automatically receive stock compensation through options, RSUs, or stocks purchased through an ESPP. Unless you actively manage this, you could find yourself overexposed to your business and with a much riskier portfolio than is appropriate.
We generally don’t like our clients to have more than 10% of their net worth tied up in a single stock. Having this type of focus puts a lot of volatility in your investments and ties your financial success to the well-being of a single asset or business.
If that company signs your paychecks as well, it introduces yet another level of risk that your financial plan may not be able to handle.
That’s a delicate balance to strike, especially in certain industries – like tech – where paying employees in stocks that tend to climb in value is the norm.
So what should you do if you find yourself in this position? This is where a comprehensive financial plan can come in. It provides you with an overview of what to do next based on everything else in your financial life, your other assets, and your overall track record to the goals you want to achieve. and what it will take to reach them.
There is no general council that works for everyone with stock-based compensation; you need to consider all of these factors when deciding whether to sell or own your business, as well as the right steps to take to manage it well over time.
Think about your goals and consider consulting with planning and tax professionals. Do not take this decision lightly, because you have a serious tool. Equity compensation can help you significantly increase your wealth over time, but only if you properly manage the risks involved in order to profit from it.
Founder, Lake Road Advisors, LLC
Paul Sydlansky, founder of Lake Road Advisors LLC, has been working in the financial services industry for over 20 years. Prior to founding Lake Road Advisors, Paul worked as a relationship manager for a registered investment advisor. Previously, Paul worked at Morgan Stanley in New York for 13 years. Paul is a CERTIFIED FINANCIAL PLANNER ™ and a member of the National Association of Personal Financial Advisors (NAPFA) and the XY Planning Network (XYPN). In 2018, he was appointed to Investopedia Top 100 Financial Advisors listing.