Stock Compensation: Definition, How It's Used, and Typical Vesting

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.

Key Takeaways

  • Stock compensation is a way corporations use stock or stock options to reward employees in lieu of cash.
  • Stock compensation is often subject to a vesting period before it can be collected and sold by an employee.
  • Vesting periods are often three to four years, typically beginning after the first anniversary of the date an employee became eligible for stock compensation.
  • Two types of stock compensation are non-qualified stock options (NSOs) and incentive stock options (ISOs).
  • Some companies award performance shares to managers and executives if certain performance metrics are met, such as earnings per share (EPS) or return on equity (ROE).

How Stock Compensation Works

Stock compensation is often used by startup companies since they typically do not have the cash on hand to pay 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 their stock-purchasing option any time before the expiration date.

Example of Stock Compensation

For example, assume that an employee is given the right to purchase 2,000 shares of stock at $20 per share. The options vest 30% per year over three years and have a term of five years. The employee pays $20 per share when buying the stock, regardless of the stock price, over the five-year period.

Types of Stock Compensation

There are different types of stock compensation, such as non-qualified stock options (NSOs) and incentive stock options (ISOs). ISOs are only available to employees and not non-employee directors or consultants. These options provide special tax advantages. With non-qualified stock options, employees are required to pay income tax based on the grant price minus the price of the exercised option.

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

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. Restricted stock requires the completion of a vesting period. This may be done all at once after a certain period of time. Alternatively, vesting may be done equally over a set period of years or any other combination management finds suitable.

RSUs are similar, but they represent the company's promise to pay shares based on a vesting schedule. This offers some advantages to the company, but employees do not gain any rights of stock ownership—such as voting rights—until the shares are earned and issued.

Performance Shares

Companies award performance shares to executives and managers only if certain specified measures are met. These could include metrics, such as an earnings per share (EPS) target, return on equity (ROE), or the total return of the company's stock in relation to an index. Typically, performance periods are over a multi-year time horizon.

Exercising Stock Options

Stock options may be exercised by paying cash, exchanging shares already owned, working with a stockbroker 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.

Article Sources
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  1. Internal Revenue Service. "Publication 525: Taxable and Nontaxable Income." Accessed Aug. 20, 2020.

  2. PwC. "Stock-based compensation," pages 3-252. Accessed Aug. 20, 2020.

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