Many successful publicly traded companies include some form of stock options—sometimes called equity compensation—as part of their compensation and incentive package offered to executives and other employees. At its simplest, the purpose of equity compensation is to provide valued employees with a direct financial incentive to help the company thrive by making them part-owners—i.e., giving them equity. You can even observe a form of this incentivization by visiting your local Walmart: eligible employees are able to purchase company stock via payroll deduction, and there is usually a sign posted prominently outside the break room with the daily stock price on it. The message is clear: “Your efforts here have an impact on this number!”
Another benefit of equity compensation that is often used by companies in the startup or growth phase is its property of compensating valued employees without using cash. The idea is that as the company grows, the value of the equity compensation also grows, benefitting both the employee and the firm.
Equity compensation can come in several forms, usually as different types of stock options. Rather than representing actual shares of stock, options represent the ability to own or control shares at a certain price. Most stock options come in one of two forms: restricted stock units (RSUs), or incentive stock options (ISOs).
When an employee receives RSUs, they are granted a specific number of company shares according to a vesting schedule. In other words, the shares cannot be sold or transferred until they have vested, which may happen over a period of time or when certain performance goals or milestones have been achieved. Suppose, for example, that an employee works for an incorporated company and is granted 1,000 RSUs as part of a compensation package. Next, suppose the RSUs have a four-year vesting schedule, meaning that 25% of the shares vest each year. At the end of year one, the employee would have 250 vested shares; at the end of year two, they would have 500 vested shares, and so on.
As already mentioned, RSUs are intended to align the receipients’ interests with the company’s stock price and also to incentivize retention: it is to the recipient’s advantage to stay with the company at least until their RSUs are fully vested. Meanwhile, as the stock price rises, the value of the RSUs increases.
Keep in mind, however, that the greatest benefit of RSUs can also be their greatest liability: their value is tied to the company’s stock price. In fact, because many companies offer additional RSUs over time as employees achieve longevity or rise up through the ranks, RSUs can also expose employees to concentrated risk. After all, if a significant portion of one’s net worth is tied up in RSUs, a decline in the company’s stock price could have a substantial impact on financial wellbeing.
The other common type of stocks options—incentive stock options or ISOs—entail the option to purchase company stock at a predetermined price, known as the “strike price.” ISOs may also provide potential tax benefits, based on the length of time they are held. If ISOs are held for at least one year after exercising them to purchase the stock and at least two years after the date they are granted, the difference between the strike price and the stock’s market value at the time of exercise is taxed as long-term capital gains, a rate that is usually lower than the ordinary income rate.
In other words, suppose an employee has ISOs with a strike price of $25 per share that were granted two years ago. The stock is currently trading at $50 per share, and the employee decides to exercise the option to purchase. If they then hold the shares for the required period of at least one year before selling, any appreciation in the stock’s value above their cost of $25 per share will be taxed at the more favorable long-term capital gains rate when they eventually sell the shares.
While ISOs offer potential tax advantages, they, like RSUs, also come with risks. If the company’s stock price falls below the strike price, the options may become worthless. Moreover, exercising ISOs often requires a cash outlay to purchase the shares, which can be a significant financial commitment. And, also like RSUs, one may find that over time, a large percentage of one’s net worth consists of a concentrated position in the company’s stock or related stock options.
Consider the following options for managing the financial risk and tax liability related to stock options:
- Diversification: It’s important to diversify the investment portfolio to mitigate the risk inherent in a concentrated position. Participants may want to think about selling a portion of their vested RSUs or stock acquired by exercising ISOs and reinvesting the proceeds into a diversified mix of assets.
- Tax Planning: Timing matters here. Fiduciary financial advisors can work with tax experts to coordinate the purchase and sale of stock or vested RSUs for maximized tax efficiency.
- Risk Management: Certain hedging strategies or alternative investments may provide protection against the risks associated with concentrated positions.
While RSUs and ISOs can be powerful wealth-building tools, they also have particular risks that must be considered. A professional, fiduciary financial advisor can be of assistance in explaining these tools and incorporating them strategically into an individual’s overall financial plan in order to achieve desired long-term financial goals.
As a fiduciary financial planner, a Rothschild advisor can provide the guidance needed to navigate the complexities of concentrated wealth. We tailor our recommendations to clients’ specific situations, whether that means diversifying a portfolio, optimizing a tax strategy, implementing risk management techniques, or developing a plan for unwinding a concentrated position. To learn more, visit our website to read our article, “Benefits of Qualified and Non-Qualified Retirement Plans.”
Disclosure: Rothschild Wealth, LLC, an SEC-Registered investment advisor and Rothschild Investment, LLC, an SEC-Regis¬tered investment advisor and broker-dealer, member FINRA/SIPC. Rothschild Wealth, LLC and Rothschild In¬vestment, LLC are affiliates and collectively referred to as Rothschild Wealth Partners TM. Founded In 1908. The information presented is not a comprehensive analysis of the topics discussed, is general in nature, is not personalized investment advice and should not be construed as a recommendation to purchase or sell any particular security or strategy. This material is for informational purposes only and is not intended to provide investment, legal, tax recommendations or advice.
