The Basics of Stock Based Compensation
Offering equity has become more common at tech companies, non-tech companies, private companies, and public companies. This form of compensation, known sometimes as equity compensation and on this website as Stock Based Compensation (SBC), is used to attract and retain talent while helping align incentives towards increasing company value. This article sets the foundation on all things SBC. It covers what types are out there, how each type is taxed, and some misconceptions when it comes to SBC such as ISOs, NSOs, RSUs, and restricted stock.
At startups backed by venture capitalists (VCs), companies owned by private equity (PE), and at some public companies, options and stock grants are commonly offered as forms of SBC, or the opportunity to own a piece of the business. If you possess an option, you do not own a piece of the company (yet). An option gives you the right to acquire stock at a set price. You must exercise that right to receive shares in the company. Stock grants like Restricted Stock Units (RSUs) or Restricted Stock Awards (RSAs) are somewhat different, and we cover those later as well.
There is a lot to consider when it comes to SBC, including vesting schedules, strike prices, grant dates, ordinary income taxes, capital gains taxes, early exercising, post-termination exercise periods, 409A valuations, liquidation waterfalls, preference stacks, and more. We’ll take it step-by-step so you can understand what each term means so that you can understand the stock compensation in your offer letter. SBC can be understood with basic algebra and a calculator, so do not worry. The goal of this article is to inform you about SBC. In any event, we encourage you to consult a legal or tax professional who has experience with SBC when it comes to your personal situation. You can also reach out to us here if you have any questions.
Let’s review the most common types of SBC:
- ISOs – Incentive stock options or incentive statutory options
- NSOs, NQOs, NSSOs or NQSOs – Non-statutory stock options or non-qualified stock options
- RSUs – Restricted stock units
- RSAs – Restricted stock, stock awards, stock grants, or restricted stock awards
Each section in this article is dedicated to a certain type of SBC. Feel free to jump ahead. Before that, there are some basics to cover:
- SBC is a form of compensation. Compensation can be cash or non-cash. Cash compensation is simple. It includes your salary, commissions, and any bonuses. Non-cash compensation is broader and includes things like vacation days, wellness stipends, retirement plans, and health insurance. The opportunity to own a piece of a business through SBC is also a form of non-cash compensation.
- You are granted SBC on a fixed date (your grant date), which you earn over a period of time in a process known as vesting. A set time period must elapse before you can exercise your options or be granted shares. Vesting schedules take many different forms but are typically straightforward. We've written an entire article on vesting schedules here.
- SBC is an arrangement between a grantor (a company) and a grantee (an employee, contractor, advisor, etc.). The key points in time for SBC are your grant date (when you receive your SBC and your vesting begins), your vesting date (when your SBC vests), your exercise date (when you can exercise your options, if you have them), and your sell date (the date on which you sell your shares). Each type of SBC has specific taxes which tie to these dates.
- Options, RSUs, and restricted stock each have an underlying price per share. When you exercise an option for instance, a company receives the costs of exercise as cash proceeds. There will often be a dollar difference between the share price you pay to exercise your option (the exercise price or strike price) and the current value of your company on the exercise date, which is your Fair Market Value (FMV). This difference between the exercise price and the FMV is sometimes known as the spread element, bargain element, or spread gain. We write more about FMV here.
- If you have equity in a company, you own a number of shares, which implies a percentage of the business. Each share of stock fluctuates in value over time. While you may hear about valuations, we would encourage you to still think in terms of share prices. When a company raises money to invest in its business, existing shareholders are diluted by new investors who receive stock in exchange for the money they invest in the company. Other activities such as acquisitions, mergers, or stock compensation to future employees all can increase the number of shares in the company, which leads to dilution (i.e. you own a smaller percentage of the business).
- An option is granted based on a set valuation for your company. Early on, a company’s valuation for the purpose of SBC is determined in good faith by a company's founders and its board (if it has one). As a company matures, it will conduct an annual valuation exercise with a third party valuation firm. This third party submits its opinion of the company's valuation to set a 409A valuation (or just 409A). Read more about 409As here. The 409A exists for tax purposes and establishes the FMV of your shares on a price per share basis, which is used for SBC. The FMV of your shares will change over time, and the FMV discussed below is always the most recent FMV.
- The 409A valuation is related but not the same as the valuation you read for a company in the press. A company’s headline value is based on the investor’s price per share and what they pay to invest. The 409A, however, is tied to the common stock valuation, which is used for the purposes of SBC. When startups raise money from investors, you often end up with multiple classes of stock, common stock for employees and founders and preferred stock for investors. You can read more about common and preferred stock here. The takeaway is there is often a disconnect between 409As and the price investors pay to invest in a company. This disconnect can lead to situations where the valuation spread is over 50%, meaning the options you receive when you join a company may have immediate value.
- You may have heard someone tell you to early your options and file an 83(b) election with the IRS. In the exciting world of SBC, certain stock plans will allow you to exercise your options before they vest. This is called early exercising (or forward exercising). We write more extensively on early exercising and 83(b) elections here. If your company allows it, it may make sense for you to early exercise. In short, early exercising is the process of exercising shares before they have vested. Thus, recognizing taxes on those shares earlier than you would otherwise. You still need to vest. In the long-term, early exercising may lower your tax burden and start the clock on qualifying for long-term capital gains tax treatment on the gain that comes from any share appreciation.
- SBC deals with ownership in a company and a claim on a percentage of future cash flows. This ownership is commonly referred to as equity. At any point in time, a company has a total equity value (in dollars) and a set number of shares. A company’s equity value divided by the number of shares gets you a price per share (or share price or stock price).
- As a company matures, both the numerator and the denominator change. You may see a share price set daily by the stock market, yearly by a valuation firm, and at other intervals by other parties like investors. If the value of your company goes up, it appreciates. If it declines, it depreciates. If the number of shares goes up, existing shareholders get diluted. If the number of shares goes down, there is no great technical term, but a shareholder owns more of the company. It quickly gets complicated as these two figures move at different rates and sometimes in different directions. It gets even more complicated as you layer on debt and multiple rounds of financing.
- There are two different classes of shares: common and preferred. Preferred shares typically accumulate over time as a company raises money. They are separate from common shares and come with additional rights, which make them more valuable. This is why the 409A valuation may be far off from the valuation investors pay to get in at. In the event of a liquidation event (an IPO, acquisition, etc.), a preferred shareholder may choose to be paid back on their investment first. This may be due to a liquidation preference stemming from their preferred stock. Liquidation preferences are so common that these shares are called preferred shares. SBC typically occurs at the common stock level where companies will have a pool of options and shares that get distributed to current and future employees. You can read more about preferred stock here.
- If you possess an option or a stock grant, you are not a shareholder nor do you have shareholder rights such as voting. Once you exercise your options and/or take receipt of your shares, then you become a common shareholder and gain the rights as described in your employer’s stock plan.
- If you exercise an option, you may not be able to sell your shares immediately. If your company is private, there will need to be a particular event for you to participate in. If your company is public, you may be allowed to sell your stock only at certain times or on a certain schedule. Some wait to exercise their options until there is a liquidity event (sometimes known as an exit), which can be an acquisition, a change of control, an IPO, or an employee tender.
- There are different types of documentation for SBC. Your company should give you grant documents when you receive your stock option or share grant. This document will be lengthy because it covers all edge cases. Once your SBC vests, you will be given a stock certificate formalizing your ownership of shares in the business. Many companies store their stock certificates digitally in Carta.
Incentive Stock Options (ISOs)
Incentive Stock Options, or ISOs, are only offered to full-time employees. People like contractors, directors, or advisors are typically awarded NSOs (described later). ISOs qualify for special tax treatment with the IRS. Here is what you should know about them:
- When you exercise ISOs, you give money to your company in exchange for shares. The amount you pay is calculated by multiplying the number of options you exercise by the exercise price.
- When you exercise your ISOs, you defer the tax on the spread between your FMV share price and your exercise price. This difference would qualify as ordinary income tax if you had NSOs (the other type of option covered below), and then you would owe tax at that point in time. Instead, you pay tax when you sell shares. Please note that if the spread between your FMV and exercise price is extremely wide or if you would generally qualify as wealthy due to your annual income, you may be subject to something called the Alternative Minimum Tax, or AMT. There are hundreds of articles on AMT, and most of them leave you with more questions than answers. We even wrote one which you can read here. Let us save you some time and recommend you go straight to a tax professional. There is a reason some call this the AMT trap! Our rule of thumb is that if you are making over $500,000 per year from a combination of your salary and exercised option stake, be on the lookout for AMT.
- You will often hear that ISOs have favorable tax treatment. It depends on when you expect to sell your shares. Please read this carefully. If you exercise your ISOs and sell those shares either within one year after exercising or within two years from your grant date, your sale will be considered a disqualifying sale (or a disqualifying disposition). A disqualifying sale triggers ordinary income tax on the spread between the sale share price and the exercise share price. If you wait at least one year after exercising and at least two years from your grant date to sell shares, you will now be subject to long-term capital gains tax on the spread between your sale price and exercise price. This sale is known as a qualifying sale (or a qualifying disposition). The qualifying sale is the benefit people seek but may not always get!.
- Very often ISOs lose their special tax treatment. Option holders tend to wait until there is a liquidity event such as an IPO or acquisition to exercise their vested options in what is known as a cashless exercise. Because the exercise and exit occur within one year, the gain is taxed at the ordinary income tax rate instead of the long-term capital gains tax rate. You can read more about common SBC wisdom and myths here.
- There is a maximum limit on the dollar value of ISOs you can exercise each year. The limit is $100,000, and you can calculate this by multiplying the exercise price by the number of ISOs you wish exercise. This limit is due to the favorable tax treatment on ISOs at exercise. Any ISOs in excess of this $100,000 limit can be converted to NSOs at the time of exercise in any given year.
- ISOs can qualify for early exercise depending on a company's stock plan. In this case, you must file an 83(b) election with the IRS within 30 days of your exercise. You can read more about early exercising and 83(b) elections here. The idea here is, you want to claim your shares at a low stock price today versus years later when the stock price may be much higher. At a lower share price, the tax bill will be lower, and you are more likely to avoid the $100,000 limit and AMT. Any business has risks, and you accept the possibility that in the future, your shares could be worth the same, less, or nothing at all.
- You need to be aware of what’s known as the 10% rule on ISOs. ISOs granted to shareholders who own at least 10% of the company must be priced 10% higher than the company’s FMV and cannot be exercised until at least five years after the grant date.
- If you leave a company with vested but unexercised ISOs, they will remain ISOs for 90 days, at which point they will either expire or convert into NSOs depending on the structure of your company’s stock plan. Some companies have extended the option exercise period beyond the standard 90 days. You can read more on exercise window here.
- The term of an ISO is 10 years. If you remain at a company and wait 11 years to exercise your ISO, they will have expired.
- ISOs are only transferable in the event of your death. Otherwise they are considered non-transferable.
Taxes on ISOs
- Grant date: No tax
- Vesting date: No tax
- Exercise date: While there will likely be a spread between the FMV share price and your exercise price, you will not be subject to tax on that spread at the time of exercise (so long as the amount you exercise in one year is less than $100,000). Although you may not have a tax burden immediately, there are cases where exercising ISOs may trigger AMT because of the massive share price appreciation which has occurred since you initially received your options. You can read more about AMT here.
- Sale date: You will either be subject to ordinary income tax or long-term capital gains tax treatment depending on your hold period. Each share will be subject to a tax on the spread between your final sale price and your exercise price. If you meet the qualifications for a qualifying disposition (selling two years after the grant date and one year after the exercise date), you will pay long-term capital gain taxes. If you do not meet both criteria, you will pay ordinary income tax.
Non-Qualified Stock Options (NSOs)
Non-Qualified Stock Options, or NSOs or NQSOs, are a class of options which do not qualify for special tax treatment like ISOs. Since they do not qualify for special tax treatment, they are known as non-qualified. Here is what you should know about NSOs:
- When you exercise NSOs, you pay money to your employer in exchange for shares. The amount you pay is calculated by multiplying the number of options you exercise by the exercise price.
- While ISOs can only be granted to employees, NSOs can be offered to employees, consultants, advisors, and board directors among others.
- ISOs are taxed once. NSOs are taxed twice. NSOs are taxed at the time you exercise your options and at the time you sell your shares. The spread between the FMV and the exercise price is taxed as ordinary income just like your annual salary. That is the downside of NSOs and the other types of SBC discussed below. You may be subject to taxes upon exercise despite not having sold any shares. As a result, many have to seek alternative financing sources to exercise their options. You can read more about option exercise financing here.
- Some companies issue NSOs instead ISOs because they are simpler to understand, easier to administer, and have a tax benefit. When you exercise your NSOs, your company earns a tax deduction because you pay ordinary income tax on any gain at exercise (the spread between your FMV and exercise price). With NSOs, your company is able to consider this gain ordinary income and recognize a tax deductible expense.
- Some consider NSOs also to be simpler for the option holder. There is no AMT involved, and tax consequences are straightforward.
- NSOs also have fewer restrictions than ISOs on stock transfers. While it is legally possible to transfer NSOs, your company’s stock plan may forbid it.
- NSOs may qualify for early exercise under your company’s stock plan. In this case, you must file an 83(b) election with the IRS within 30 days of exercise. You can read more about early exercising here.
Taxes on NSOs
- Grant date: No tax
- Vesting date: No tax
- Exercise date: You will pay ordinary income tax on the spread between the current FMV share price and the exercise price. If you are still an employee of the company when you exercise, you will also pay employment tax (Social Security and Medicare) on that spread.
- Sale date: Depending on the length of time you hold shares after the exercise date (either over or under one year), you will pay either long or short-term capital gains tax on the difference between your sale share price and the FMV share price at the time you exercised your options.
Restricted Stock Units (RSUs)
Restricted Stock Units, or RSUs, are a stock grant which promises to provide either shares (most frequently) or cash at some point in the future. An RSU is not a type of stock option. Here is what you should know about RSUs:
- Like options, RSUs are frequently accompanied by a vesting schedule that is time-based and in some cases performance based (e.g., based on a revenue target or a liquidation event like a company sale).
- If you have RSUs, valuing them is simple. At any time, you can multiply the number of units by the current share price to get the value of your equity package. If your company is private, the current share price is the FMV.
- RSUs are a unit award. They entitle you to receive shares of stock or cash on a future date. You will not need to pay the company any money to acquire your shares, so RSUs do not have an exercise price. When you satisfy your vesting conditions and your company gives you the stock, a taxable event occurs.
- An extension to this concept is that if you have RSUs which vest over several years, you will receive your shares whether the company grows in value or not. This nuance is important because RSUs therefore have some downside protection compared to stock options. Your RSUs will always have some value, even if your company does not achieve their home run scenario.
- Like ISOs or NSOs, RSUs have similar features such as a grant date, a vesting scheduling, and once you receive your shares, standard shareholder rights. RSUs convert to common stock as they vest.
- RSUs do not qualify for early exercise because they are a unit award. As explained below, you will pay ordinary income tax on the FMV of your stock when it vests and when you take receipt of the shares. Some dislike RSUs for this reason. If a company experiences rapid growth and a dramatic increase in the company's value, the tax implications are immediate and can be greater than some can afford.
- RSUs are common at late stage, private companies and public companies. At private companies, a company’s share price may have appreciated to such a point that it would be prohibitively expensive to exercise an option. RSUs are also given by private companies which are planning to go public in the near future.
- RSUs do expire. Each company will set its own RSU expiration date, which is typically 5, 7, or 10 years following the grant date. RSU expiration may occur when companies include going public as part of the vesting conditions.
- At public companies, there is a liquid market for the company’s stock. As RSUs vest and taxes come due, you can immediately sell some of your shares to have the money available to pay taxes on the shares. Some companies will even pay the tax liability on behalf of the RSU holder. Do not expect it, but you can ask about it.
- When your RSUs vest and you receive shares, they are considered compensation to your employer and are a tax deductible expense like salary or wages.
Taxes on RSUs
- Grant date: No tax
- Vesting date: It depends. Taxes on RSUs are due when you receive your shares, but a taxable event does not always occur on the vesting date because you may not receive shares on the date you vest. Your employer may or may not allow you to choose when you receive your shares, so you can push off the taxable event for a period of time. When you do ultimately receive your shares, you will pay a tax based on the FMV of your shares at that time. If you expect your stock to appreciate and you can afford the tax at the vesting date, you may want to consider getting your shares as soon as possible, in other words, on the vesting date. This nuance is the key difference between RSUs and restricted stock (below).
- Sale date: The spread between your share price at sale and the FMV of your shares when you received them is a capital gain. Depending on the length of your hold period (over or under one year) after receiving your shares, you will pay either long or short-term capital gains tax.
Please note that if your RSUs are paid in cash instead of shares, then the tax implications will differ and likely be simpler (i.e. you will probably pay ordinary income tax on the cash you receive in lieu of shares). Please consult a tax professional who can advise based on your situation.
Restricted Stock, or Restricted Stock Awards (RSAs), is another form of SBC often given to founders and early employees. Like RSUs, RSAs are not a type of stock option. Here is what you should know about RSAs:
- Restricted stock does not require a cash exercise to acquire shares. Similar to RSUs, you will likely have a vesting schedule, which is performance and/or time-based. When an RSA vests, you will receive your shares, and a taxable event occurs.
- The main difference between RSUs and RSAs is that because RSUs are a unit award, they do not become common shares until the unitholder vests and takes receipt of their shares. However, a person who holds RSAs is a shareholder on day one, even before their RSAs have vested. That person can accrue dividends. That person can vote. The only thing that person cannot do is sell their shares because they still need to vest and satisfy any other performance conditions.
- At the start of a company, many founders will grant themselves RSAs in lieu of options. The RSAs are sold at no cost (because the company is worth virtually nothing), and each co-founder may reverse vest over a period of years to earn their shares. So long as they stay with the company, the shares become theirs over time.
- You might have figured this out when you heard it called restricted stock but RSAs are by definition restricted, meaning RSAs are nontransferable until you acquire your shares by satisfying certain performance conditions, usually vesting. Once you vest, your shares are common stock and are transferable.
- If you have RSAs, valuing them is simple. At any time, you can multiply the number of units by the current share price to get the value of your equity package. If your company is private, the current share price is the FMV.
- RSAs may qualify for early exercise depending on your company’s stock plan. Early exercising will start the clock on qualifying for long-term capital gains tax treatment and may allow you to pay a lower tax rate at sale. In this case, you must file an 83(b) election with the IRS within 30 days of your exercise. You can read more about early exercising and 83(b) elections here.
- Some companies withhold income tax on restricted stock, which reduces an individual’s tax burden. You can inquire about this if you are offered a compensation, which includes restricted stock.
- Unlike options, there are no exercise provisions to RSAs. When they vest, they become yours, and you will then owe tax on them. If you have early exercised your restricted stock, you are accepting the risk that your shares could decline in price before you vest, and the share price may ultimately never recover.
Taxes on Restricted Stock
- Grant date: No tax, unless you early exercise and file an 83(b) election. If you do that, you will pay ordinary income tax on the FMV of your stock at the grant date.
- Vesting date: If you paid no tax at the grant date, your shares are taxed as ordinary income based on the FMV of your shares at the vesting date. If you early exercised and filed an 83(b) election, you do not pay any tax on the vesting date.
- Sale date: If you paid tax at the vesting date, the difference between your sale price and FMV on the vesting date is subject either to short-term or long-term capital gains tax depending on the length of your hold period (over or under one year). If you early exercised and paid tax on the grant date, you will record a capital gain on the difference between your sale price and the FMV of your shares at the grant date.
If you early exercise your RSAs, remember that you still need to vest your shares.
Stock Appreciation Rights, Phantom Stock, Founders Shares, and more
Other types of SBC include Stock Appreciation Rights (SARs), phantom equity, Performance Share Units (PSUs), warrants, and Founders Stock. In short:
- Stock appreciation rights, or SARs, are what they sound like: the right to the appreciation of a share price. Like other SBC, SARs have a grant date, an underlying exercise price, and a vesting schedule. Your gain will be the number of SARs multiplied by the gain of a single share. If your stock appreciates, your employer may pay you with cash or common stock. If you receive cash, you will pay ordinary income tax as if you were paid a cash bonus. If you receive common stock, you will pay ordinary income tax on the difference between your exercise price and the FMV of your stock at exercise.
- Phantom stock is cash compensation disguised as SBC. Stockholders are given a set number of hypothetical shares. Following a liquidation event or some performance hurdle, you receive a cash payment equal to the share price of your phantom stock. No stock actually changes hands. You do not become a shareholder in the business, and you will ultimately pay ordinary income tax on any cash you receive.
- Performance share units, or PSUs, are a common form of SBC at public companies. PSUs typically function like RSUs in that they have a vesting schedule and a set of business targets to achieve. PSUs can convert into shares, cash, or a combination of both. Any cash payment will be taxed as ordinary income, and PSUs that convert into shares will be taxed as ordinary income based on the FMV of the stock you receive. Because there is a taxable event when the shares are received, you can see why this is more common among public companies than private companies. You may need to sell some shares immediately to afford the tax burden.
- Warrants may be issued to employees, advisors, contractors, and investors. Like options, warrants are a right to purchase shares in a company at a designated share price for a predetermined time period. You must exercise a warrant and pay the company cash to receive shares in return. Most warrants will have expiration dates, and some will have vesting schedules. As a result, the tax implications vary so please consult a tax professional to discuss your situation.
- Founders stock, or founders shares, is unique because it sounds like a special type of share class with favorable tax benefits, but it is actually just the name of shares issued at the start of the company before outside capital is raised. Founders stock is granted to co-founders and potentially early employees. There are tax advantages to founders stock in so far as it represents equity granted early on in a company’s life. At sale, holders of founders shares may qualify for long-term capital gains tax treatment, QSBS tax treatment, and a Section 1045 Rollover. You can read more about QSBS and Section 1045 Rollovers here.
For those who are are interested, below are more topics related to equity ownership and SBC:
- The companies issuing SBC generally fall into three buckets: (1) a company which is VC-backed, (2) a company which is PE-owned, and (3) a company that is public or has been acquired by a public company. Once you reach (3), compensation changes to weigh performance more heavily. The benefit of being in bucket (3) is that financial information about your company is readily available through the SEC. If you work at a company that is (1) or (2), it may be difficult to get financial information about your company.
- When you sell stock at a gain, you will generate a capital gain and be required to pay tax. Depending on whether you hold your shares for over or under one year, you will pay either long-term or short-term capital gains tax. Short-term capital gains are taxed at the same rate as ordinary income, and most resources online use the two terms interchangeably. Capital gains tax rates are the same or better than ordinary income tax rates in essentially all situations. When you are subject to ordinary income taxes, it is as if you received a cash wage, and for that reason, you will pay taxes for Social Security and Medicare by law under the Federal Insurance Contributions Act (FICA). The FICA rate is a federal tax, set annually. In 2019, an individual paid 6.2% for Social Security and 1.45% for Medicare.
- A quick note on income taxes since we are not tax professionals. There are two types of tax you will see in the wild – (1) ordinary income tax and (2) capital gains tax. Ordinary income tax covers income generated over the normal course of a year, so most cash comp falls in this bucket. Capital gains tax covers assets which appreciate or depreciate in value. Assets held for more than one year are considered long-term, while those held for under one year are considered short-term. Taxes on short-term capital gains and ordinary income are the same. Long-term capital gains tax is favorable because the rate is lower than ordinary income tax. Based on where you live, your income bracket, and the types of assets you own, you will likely be subject to a mix of (1) and (2). This is what a tax professional will help you with. When you do discuss this with a professional, ask them if your shares qualify for Qualified Small Business Stock (QSBS). It’s a major potential tax benefit many overlook or have never heard of. You can read more on QSBS here.
- A company can raise primary capital or sell existing shares in the company. It is important to distinguish between the two because the former dilutes existing shareholders, while the latter does not.
- This entire article pertains to SBC in the US. If you want to understand it in Europe, you can read more here.