What is Stock Compensation
Stock compensation is a way corporations use stock options to reward employees. Employees with stock options need to know whether their stock is vested and will retain its full value even if they are no longer employed with that company. Because tax consequences depend on the fair market value (FMV) of the stock, if the stock is subject to tax withholding, the tax must be paid in cash, even if the employee was paid by equity compensation.
BREAKING DOWN Stock Compensation
Stock compensation is often used by startups, since they typically do not have the cash on hand for paying employees competitive rates. Executives and staff may share in the company’s growth and profits that way. However, many laws and compliance issues must be adhered to, such as fiduciary duty, tax treatment and deductibility, registration issues and expense charges.
When vesting, companies let employees purchase a predetermined number of shares at a set price.
Companies may vest on a specific date or on a monthly, quarterly or annual schedule. The timing may be set according to company-wide or individual performance targets being met, or both time and performance criteria. Vesting periods are often three to four years, typically beginning after the first anniversary of the date an employee became eligible for stock compensation. After being vested, the employee may exercise his stock-purchasing option any time before the expiration date.
For example, an employee is given the right to purchase 2,000 shares at $20 per share. The options vest 30% per year over three years and have a term of 5 years. The employee pays $20 per share when buying the stock, regardless of the stock price, over the five-year period.
Stock appreciation rights (SARs) let the value of a predetermined number of shares be paid in cash or shares. Phantom stock pays a cash bonus at a later date equaling the value of a set number of shares. Employee stock purchase plans (ESPPs) let employees buy company shares at a discount. Restricted stock and restricted stock units (RSUs) let employees receive shares through purchase or gift after working a set number of years and meeting performance goals.
Exercising Stock Options
Stock options may be exercised by paying cash, exchanging shares already owned, working with a stock broker on a same-day sale or executing a sell-to-cover transaction. However, a company typically allows only one or two of those methods. For example, private companies typically restrict the sale of acquired shares until the company goes public or is sold. In addition, private companies do not offer sell-to-cover or same-day sales.