In general, the 7 types of equity award can be categorized under 3 main groups: Share-based awards, Options-based awards, and Equity Awards Plus Performance.
Three Share-based awards: might worth something at vesting (if the company still exists), but employees have little to no control over the timing of taxation.
1. Restricted Stock:
a. Actual shares of the company.
b. Employees are restricted to sell the shares until they are vested, but they can receive dividends if the company pays for it on their unvested and vested shares.
c. The dividends are usually reinvested into the shares which will have the same vesting schedule from the shares those dividends attributed to previously.
d. It’s guaranteed to be worth something at vesting, and the shareholder has the voting rights.
e. It is taxed as wages when they vest.
2. Restricted Stock Units (RSUs):
a. Like restricted stock and the most common type of equity compensation used today.
b. A promise to deliver a specified number of unrestricted shares on the vesting date, not actual shares of the company.
c. Not eligible for dividends, but some employers do “dividend match”.
d. No voting rights.
e. It is taxed as wages when they vest.
3. Phantom Stock:
a. An RSU that can be settled in cash or company shares at vesting.
b. Privately held companies more commonly use it.
c. Publicly traded companies will use it to avoid putting additional shares of company stock into circulation or if the administrative costs of setting up another plan are too high.
Three Options-based awards: employees can control when they are taxed, but they could expire worthless if the stock price goes down or remains unchanged.
1. Incentive Stock Options (ISOs):
a. Represents a contractual right to buy employer stock at a predetermined price (the “strike price”) within a certain period, regardless of the stock’s price at the time of exercise.
b. The period can be up to 10 years from the grant date, but ISOs typically can’t be exercised until they vest.
c. The maximum value of ISOs an employee can vest during a calendar year is $100k. This limit is based on the stock’s price when the ISO was granted (typically the strike price), with any portion over the limit being converted to nonqualified stock options (NSOs).
d. ISO is the only type of equity award eligible for long-term capital gain treatment (to qualify, the employee must hold the stock for at least 1 year from the date they exercise the ISO and at least 2 years from the grant date. It is called the “qualified disposition”).
e. No taxation until the shares are sold or cashed out. The difference between the stock’s price at exercise and the strike price is subject to the Alternative Minimum Tax (AMT).
f. Vested ISOs must be exercised within three months or less of termination of employment.
2. Nonqualified or Nonstatutory Stock Options (NSOs/NQSOs)
a. NSOs are typically ISOs but are not subject to the $100k annual vesting limit.
b. They have less favorable tax treatment than ISOs, but they are not subject to the AMT.
c. They are allowed to be issued at a discount, but they typically aren’t because of adverse tax implications.
d. They are taxed when the employee exercises them. The amount is the difference between the strike price and the stock’s price at the time of exercise and is taxed as income.
3. Stock Appreciation Rights (SARs)
a. Its value is determined by the amount of the employer’s stock increases (or “appreciates”) between the grant date and whenever the employee exercises them.
b. Depending on how the employer designs the plan, SARs are exchanged for cash or shares of company stock when the employee exercise them.
c. For share-settled plans, divide the current value of SARs by the company’s stock price at the time, and that’s how many shares the employees can gain when they exchange them.
d. They are taxed as income when the employee exercises them.
One Equity Awards Plus Performance: the introduced equity awards give the employees a vested interest in the company’s success, and the performance awards take it to the next level.
1. Performance Awards
a. A multiplier is applied to the number of shares/options at vesting, based on performance relative to a target goal.
b. The goals are often centered around key performance indicators (KPI) that the employees have some degree of control.
c. The idea is to set goals for the employee that, is achieved, will help the company grow.
d. The taxation of a performance award follows the tax treatment of the actual award type.
The article is based on Traverse Planning’s "Equity Compensation 101: The 7 Different Types of Equity Awards - Traverse Planning".