How Does Stock Based Compensation Work? All About RSUs, Stock Options, & ESPP

Equity is an increasingly popular form of compensation in today’s corporate landscape. And for good reason: equity-based compensation provides employees with a sense of ownership in the organization’s success, serves as a powerful incentive to drive performance, and helps with employee retention.

And stock based compensation doesn’t only benefit employers. If managed skillfully, equity can also be a powerful tool for employee wealth-building!

In this technical deep dive, we’ll explore three common forms of equity-based compensation (sometimes used synonymously with stock based compensation): Restricted Stock Units (RSUs), stock options, and Employee Stock Purchase Plans (ESPPs). We’ll delve into their mechanics, taxation, vesting schedules, and factors to consider in order to make informed decisions about these benefits.

For context, I am a 24 year old software engineer and personal finance content creator (you can find me on Instagram @organized.finance or on my blog). I have received RSU grants as part of my 9-5 compensation, and have also participated in my company’s ESPP program—read on for more details!

Note: This article is purely for educational purposes and is not investment advice. Please do your own thorough research before making any financial decisions.

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Deep Dive Into Equity Based Compensation

Before we expand on the three types of equity covered in this post, let’s lay down some groundwork.

What is Equity?

Equity refers to the ownership that individuals or entities hold in a business. As a shareholder, your equity entitles you to a share of the company’s profits and a voice in certain decisions affecting the company. Receiving stock based compensation is one way of receiving equity.

Equity based compensation is a form of employee incentive that grants ownership in a company to its employees. Instead of (or in addition to) providing traditional cash rewards, companies offer employees shares of company stock or stock options as a way to align their interests with the company’s success and encourage long-term commitment.

What is a Vesting Schedule?

A vesting schedule is a timeline that outlines when employees become eligible to own or fully access their granted company shares. It encourages long-term commitment by gradually granting ownership rights over a specified period, usually tied to the employee’s tenure with the company.

For example, if your stock grant has a time-based 4-year vesting schedule, you’ll be granted your shares gradually over the course of 4 years.

Oftentimes, stock grants also come with an initial “cliff”. A 1-year cliff, for example, signifies that you won’t be able to access your shares or options until you’ve completed your 1st year of employment at the company. This “cliff” serves to incentivize employee retention.

Now that those definitions are out of the way, let’s discuss RSUs, stock options, and the ESPP:

Restricted Stock Units (RSUs) – One Type of Stock Based Compensation:

• Definition: RSUs represent a promise to deliver a set amount of company stock to an employee as stock based compensation at a future date, subject to specific conditions.
• Vesting: RSUs typically have a vesting period during which the employee must remain with the company to earn the rights to the granted shares.
• Taxation: Your RSUs are considered part of your compensation, so they’re included in your taxable income when they vest. Typically, your employer will automatically sell a portion of your granted shares when they vest to cover the tax withholding requirement. I recommend asking your employer about their withholding procedure for RSU grants, as it may impact your overall financial planning.
• What else you should know: Once your shares vest, they’re treated like normal shares of stock. So if you eventually sell those shares, you will be taxed on the capital gains from that sale. As with any other stock sales, you’ll be taxed at the (lower) long-term capital gains rate if you’ve held the shares for at least one year following the vesting dates. If you’ve held the shares for less than 1 year, the sale will be treated as short-term and you’ll be taxed at your ordinary income rate.

Your RSU grant might look something like this (note the 1-year cliff):

You will be granted 1,000 shares of Company A. You will receive 25% of the grant (250 shares) on the first anniversary of your start date and an additional 6.25% (62.5 shares) on a quarterly basis thereafter, as long as you remain employed by Company A.

Stock Options:

• Definition: Stock options grant employees the right to purchase company stock at a predetermined price, known as the exercise price or strike price.
• Vesting: Like RSUs, stock options usually have a vesting schedule (often with a cliff) to increase employee retention.
• Taxation: Taxation on stock options can vary depending on the type (incentive stock options vs. non-qualified stock options) and the specific circumstances of exercising and selling the options. Ask your employer for details on your stock options and the taxes you’ll incur upon exercising them.
• What else you should know:
  • You may choose to exercise your stock options and purchase company stock at the predetermined price, but you are not obligated to. You should analyze the value of your shares, the taxes you’ll incur, and the upside of the stock before choosing to exercise those options.
  • One more thing to keep in mind: if you do plan to exercise your stock options, plan ahead to make sure you have enough funds to cover the cost of the purchase! If you don’t have the cash on hand, you may be able to exercise-and-sell through your brokerage: this is when your brokerage uses the money from the sale to cover the cost of the shares.

For example, say you have stock based compensation options that grant you the right to purchase 100 shares of company stock at $1/share, with a 4-year vesting schedule and a 1-year cliff. After 1 year of working at the company, you are granted 25 options. At that time, the company stock is valued at $3/share. You decide to exercise your options, and spend $25 purchasing 25 shares of stock at $1 share. Those shares are worth $75, so you’ve made a $50 profit (pre-tax).

Employee Stock Purchase Plans (ESPPs):

• Definition: ESPPs enable employees to buy company stock at a discounted price.
• Offering Periods: The ESPP offering period is the period of time during which after-tax money is deducted from your paycheck into the plan in preparation for purchase. ESPP offering periods are typically 6, 12, or 24 months long.
• Taxation: The tax treatment of ESPPs can differ based on the type of plan (Qualified vs. Non-Qualified) and whether the shares are sold immediately or held for a specified holding period. Ask your employer for details on how your ESPP shares will be taxed.
• Maximum Contribution: Per the IRS rules, you cannot purchase more than $25,000 worth of company stock (based on the fair market value of the stock at the grant date) per calendar year through your ESPP.

Tips for managing your stock based compensation:

1. Remember to diversify: While equity-based compensation can be a great perk, it’s important to remember that a chunk of your income (for many people, the biggest chunk) is also coming from your employer. If the company shuts down and its stock plummets, you’ve lost not only your 9-5 income, but also your investments in the company. Avoid putting all your eggs in one basket and make sure your investments are diversified.
   • Also, remember that once you own company shares, those shares are subject to market fluctuations just like any other stock.
2. Tax planning: Tax planning can save you a lot of money when it comes to stock based compensation. For example, the amount of time you wait before selling your RSUs can impact the rate at which your sale is taxed (short-term vs. long-term capital gains). Make sure you understand the tax implications of your equity.
3. Evaluate your company: If you’re considering accepting a job offer that comes with equity as compensation, how should you determine the value of that equity? If the company is already public, take a look at its historical share price. Getting a better sense of the company’s financial health, growth prospects, and industry position can also help you better assess your equity’s potential value.

My experience with stock based compensation

When I signed on with my current employer, I received an RSU grant with a 1-year cliff. Here’s how much I make from my 9-5 as a software engineer, including my equity-based compensation.

My employer also rolled out an ESPP (with a 15% discount) soon after I began working. I joined the ESPP, and soon realized that I was becoming far too heavily invested in one company (my employer). I then began selling some of my company shares to diversify. I made sure to only sell shares that I had held for over 1 year so that I would be taxed at the long-term capital gains rate.

Currently, my employer’s stock based compensation comprises about 12% of my investment portfolio—which still feels high to me. I plan to keep it around that level (or lower) while I’m still working at this company. Once I move on to another company, the percentage of my portfolio that is invested in my current employer’s stock will likely steadily decrease, as I won’t be receiving stock grants from them periodically.

Why understanding your equity matters

Your equity based compensation has the potential to accelerate your wealth-building journey, so it’s especially important to understand the nuances of your grant and to consider how best to maximize its benefits while managing potential risks. By making informed decisions, you can harness the power of your equity to build wealth and achieve your long-term financial goals!

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