Taking Stock: 10 Terms Critical To Understanding Stock Compensation Stock compensation is alluring for employers and employees alike.
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Companies often use stock compensation to attract and retain talent without having to overpay in cash. Plus, tying an employee's personal wealth to the success of the business aligns incentives in a powerful way.
The same dynamic applies to the employee — they're investing in the business and their own performance. Stock compensation means you could be multiplying money and betting on your own work as a stakeholder who bought in at a reduced price. It sounds pretty straightforward. But this is finance and tax, and nothing is straightforward. Not when there's an unpredictable market and miles of tax code involved.
The term "stock options" is so prevalent that those new to the concept are often too embarrassed to ask what it actually means. Stock compensation, even in its most basic form, requires an understanding of not only the types of options, but the terms and logistics involved with vesting and exercising. And yes, those terms include "vesting" and "exercising."
Comprehending key terms helps you unlock a wider range of knowledge that will allow you to take full advantage of the practice, whether you're a bootstrapping entrepreneur conserving capital, a success story entering a new phase of fundraising or a new hire waiting for your offer to blossom into earnings. Here's where to start:
1. Stock options
Stock options aren't shares handed over to employees for a job well done. The term refers to the granted right of an employee to purchase stock at a fixed rate, which simultaneously generates capital for the business and puts the employee in a position to earn big should the value rise. "Stock options" is a blanket term, so it's important to understand the type of option being granted before you get too excited about the potential to earn from them.
2. Incentive stock options (ISOs)
These options are granted to the employee after a certain amount of time passes or goals are achieved, which incentivizes an employee to stay with the company. It's considered a reward for loyalty and can typically mean purchasing the stock at a greatly reduced rate that's also taxed lower.
3. Nonqualified stock option
These are often offered as a form of compensation for newer companies. They often come at a much lower price, but they're also heavily taxed upon purchase and sale, which makes them less alluring.
The act of purchasing stock once you're allowed to do so under the vesting terms outlined in the stock option agreement.
You don't want to hand your new employee valuable stock and watch them walk away and sell it for a profit (and at the cost of revenue and an employee). As such, most options vest, or mature, as certain conditions are met. Employees cannot exercise their right to buy stock until the vesting conditions are met. Options are commonly vested over time, with a certain amount vesting each month until an employee is fully vested.
6. Cliff vesting
Options that have cliff vesting require an employee to remain with the company for a period of time, one year for example, prior to any of the options vesting. If the employee leaves prior to the cliff vesting date, none of the options vest. Employers benefit from this, because it encourages employee retention. For employees, it can be less appealing, since it means they would lose all of their stock options if they leave before the cliff.
7. Performance-based vesting
This is vesting based on merit. Hit a certain benchmark, and you'll earn your shares. This helps align employees with business strategy and gives them an incentive to grow the business.
Acceleration means that all of the stock options automatically vest if the company is acquired. Options are typically exercised, and the stock is sold immediately as part of the sale. Say an employee's contract provides a 20,000-share grant with a four-year vesting schedule and a one-year cliff and acceleration. If the company is acquired just three months after the employee is hired, all 20,000 shares would vest and be sold automatically, and the newly hired employee would pocket a handsome sum.
9. Restricted stock grant
Also known as restricted shares, this is a form of stock compensation handed over to an employee with — you guessed it — restrictions on when and how they're vested. They typically take several years to vest, and their entire value is required to be taxed as income the year they vest, which can create an extra burden for both the employer and employee.
10. Strike price
In the simplest terms, this is the price at which an employee can exercise an option. The strike price remains the same as the options vest, but there's also a limited time an employee has to make the purchase. So strike fast, especially if the price is lower than the value of the stock itself (or if you see the value rising). And strike early, since under today's tax law, that could mean you pay a lower capital gains rate at the exit and thus retain more cash.
Things get more complicated from there, but those are the baselines. Further understanding of how to fully take advantage of stock options greatly benefits from further research or the help of a financial professional.