Equity-Based Compensation: A Primer
Equity (stock)-based compensation is a way for companies to reward their executives with shares of stock or stock options. These types of compensation can be an important part of an executive’s overall compensation package, and can provide a number of benefits to both the executive and the company.
The IRS defines equity-based compensation as “any compensation paid to an employee, director, or independent contractor that is based on the value of specified stock (generally, the stock of the employer, which may be a corporation or a partnership).” Common forms of equity compensation include stock options, restricted stock awards and units, performance share units, and stock appreciation rights.
Stock options: Stock options give an executive the right to purchase a specific number of shares of company stock at a predetermined price, known as the exercise price. The individual can then choose to exercise their options and buy the shares at the exercise price, or they can hold on to the options and wait for the stock price to rise before exercising them. This can provide an executive with an opportunity to profit from the appreciation of the company’s stock. The most common form of options used today are Nonqualified Stock Options (“NQSO”). Any gain from NQSOs is considered ordinary income. Less common option awards are Incentive Stock Options (ISOs). With proper planning, the ultimate difference between sale price and the ISO strike price may be treated as a capital gain.
Restricted stock awards and units. Restricted stock awards and units are commonly awarded to management. An employee receives shares but does not take possession of them until certain requirements are met, such as years of service. Companies pay out this type of award in the form of cash or shares.
Performance share units. Performance share units are performance based stock grants awarded to management. They vest contingent on meeting common performance targets. Vesting may be based on meeting such company goals as total shareholder return (“TSR”), earnings per share (“EPS”), sales, return on assets, return on equity, and levels of customer satisfaction. In some cases, the targets are based on company performance relative to its peers.
Stock appreciation rights. A Stock appreciation right (“SAR”) offers a bonus equal to the appreciation in the company’s stock, usually over a vesting period of several years. When the employee leaves the company, the company buys back the vested shares and unvested shares expire worthless.
Stock-based compensation presents some advantages for both the executive and the company. For the executive, receiving stock or stock options can be a way to participate in the success of the company and potentially earn a significant return on their compensation. For the company, offering stock-based compensation can help to attract and retain top talent, as well as align the interests of executives with those of the company and its shareholders.
In addition to some advantages, stock-based compensation can also present risks. The value of the stock or options can go down as well as up, so executives can potentially lose money with this compensation arrangement. Also, the tax treatment of stock-based compensation can be complex. That’s why it’s important to seek professional advice to understand the tax obligations. A financial advisor who specializes in stock-based compensation can work with you to help analyze the level of concentration you have in company stock and options, your time horizon, risk profile, and upcoming cash-flow needs. If you have a choice among compensation types, your age, time horizon and risk tolerance may favor restricted stock over nonqualified or the reverse. The longer your time horizon, the longer you can wait to take action on your stock options.
We believe taking a thoughtful and strategic approach to equity-based compensation canbe rewarding and well worth the time and effort. Many executives leave money on the table when they base equity compensation decisions on short-term considerations or fail to consider economic, tax, timing and other variables. Careful and thorough consideration of these variables can help guide you, along with the personal and life goals for you and your family.
If you have questions about your stock-based compensation, Savant’s goal is to help. Our Certified Equity Professionals work with a variety of senior-level executives to help them understand their equity-based compensation plans and achieve their financial goals.
Savant Wealth Management (“Savant”) is an SEC registered investment adviser headquartered in Rockford, Illinois. Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk. You should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment advice from Savant. The scope of the services to be provided depends upon the needs of the client and the terms of the engagement.
Matthew P. Witter
Financial Advisor