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Many software engineers will have stock options included in their packages. Here’s everything you need to know about managing these.
In the dynamic landscape of the 2010s job market, rapid growth fueled by tech companies saw a surge in hiring, largely benefiting employees. With a recent shift towards profitability however, firms have pivoted, resulting in significant layoffs and tipping the scales in favor of employers. Amidst this evolving landscape, it is more important than ever to understand the nuances of equity compensation, especially when a compensation package includes stock options and restricted stock units (RSUs).
Equity compensation, sometimes called stock compensation, offers employees an opportunity to own a part of their company through non-cash benefits like stock options and RSUs. In simple terms, the company is paying part of your compensation via ownership of the company instead of cash. Startups that are unable to offer high salaries due to cash constraints often include equity compensation to make their offer more competitive. Established companies may also utilize equity compensation to align employee success with company performance, and enhance retention and motivation.
Where employees may anticipate sharing in the company’s success through increased progression opportunities and larger bonuses during periods of growth, stock ownership offers a more concrete method of sharing success, particularly if the company’s share price appreciates.
Equity compensation can make up a substantial portion of an employee’s total compensation package, sometimes comprising 50% or more for engineers at early-stage companies or in senior leadership positions. While equity compensation presents significant upside potential, it also introduces different risks to cash compensation that need to be understood.
What are your stock options?
Stock options are commonly granted at private companies and more typically restricted to senior-level employees at public companies.
They provide the opportunity to buy company stock at a predetermined fixed price, known as the strike price, typically set at the current market value, and are valid for a specified period, often 10 years. This can turn into a significant financial gain if the price of your company stocks grow over time, since you can purchase shares at the lower strike price and sell them at the higher market value.
Employers incentivize long-term commitment by implementing vesting schedules. Vesting means that you have to be employed for a certain amount of time, determined by the employer or the specifics of the options grant, before options can be exercised to purchase company stock. A common time-based vesting structure is four years, with 25% vesting after the first year and subsequent monthly (1/36) or quarterly (1/12) vesting for the remaining three years. In some instances, particularly for senior-level employees, companies may add performance-based vesting criteria, such as achieving revenue or profit targets.
Non-qualified stock options, or NSOs, are generally subject to ordinary income tax on the gain at the time of exercise, referred to as the bargain element, between the strike price and the fair market price at the time of exercise. For instance, if you exercise NSOs with a strike price of $10 while the shares trade at $25, the $15 difference is taxed as ordinary income. Employers may withhold taxes from this gain, similar to regular salary withholding.
Another type of stock options, called incentive stock options, or ISOs, are generally only offered to US-based employees, as they offer two potential tax advantages specific to US tax law.
A great benefit of stock options, whether they are NSOs or ISOs, is that your money remains unexposed to risk until they are exercised. In this way, stock options allow you to participate in company success without an initial financial commitment. The downside is that if your company stock performs poorly and the price never increases above your strike price, your options will expire as worthless. While there is no money at risk, stock options form part of your compensation, potentially representing a missed opportunity for higher cash earnings instead.
Review your options document to find important details such as your vesting schedule, strike price, and expiration date. Since plan rules vary, carefully read your company plan and seek guidance from a tax professional or financial planner if you have any questions.
Understanding Restricted Stock Units
Restricted stock units (RSUs) are the most common type of equity compensation and are typically offered at public companies or if a private company reaches a more stable valuation. Unlike stock options that grant the option to exercise and buy shares, RSUs provide actual shares of company stock upon vesting. The easiest way to think of RSUs is that the company is paying you with their company stock by depositing their shares into your brokerage account, instead of depositing cash into your bank account.
RSUs also typically have a vesting schedule. The value of the shares at the date of vest is taxed as ordinary income. Your company will sell some shares for tax withholding, and the remaining shares are deposited into your brokerage account. At this point, your company shares are treated exactly the same as if you purchased them on the open market, subject to your company’s trading rules.
The benefit of RSUs is that they are simple compared to options, as there’s no need to concern yourself with timing or quantity of exercise. RSUs also carry less risk relative to stock options. As long as your stock price doesn’t drop to $0, they will always be worth something.
For example, suppose you’re granted 4,000 RSUs that all vest in one year, with the share price at $50 both at grant and vesting. The RSUs would be valued at $200,000. If the share price rises to $70 at vesting, the RSUs would then be valued at $280,000.
Alternatively, consider being granted 10,000 stock options with a strike price of $50, expiring in one year. If the share price remains at $50 throughout the year (rather than vary as it normally would), the options would expire worthless. However, if the share price rises to $70, the options would be valued at $200,000, as you could exercise them to buy shares at $50 and sell them at $70.
When to negotiate your stock options
When evaluating job offers, it’s crucial to consider the entirety of the total compensation package, including cash, equity, and additional perks such as pension contributions and healthcare coverage. Although there’s limited room to negotiate certain benefits like pension contributions and healthcare, you often have more flexibility with equity compensation and salaries, making these components crucial in your negotiation strategy.
Companies commonly provide an initial grant of options or RSUs with your job offer, supplemented by refreshers either annually or as a bonus. While refreshers are great, the initial grant tends to be the most substantial. Therefore, make sure to negotiate a fair deal upfront to ensure you receive adequate compensation from the outset.
When negotiating equity compensation, weigh the potential value and risks. While RSUs are generally more valuable than stock options, options can become more valuable if the company valuation grows significantly. Remember that early startups often offer only options due to financial constraints. Consider the company’s prospects for success, including the timeline to a potential liquidity event, alongside your career intentions.
If you only plan to be there for two years, a four year grant may not be worth as much. Prospective employers sometimes give overly optimistic projections for growth, so research the company’s performance and industry standards independently to ensure you’re making an informed decision. Equity grants vary based on factors like your role, experience, and the company’s size and stage. RSU grants can range from hundreds to millions for established companies, while for early stage companies, option grants can range anywhere from < 0.1% to over 1% of the company depending on the role.
Don’t sign an offer if you don’t understand the value of your offer. Don’t be afraid to ask your prospective employer for more information and to consult an independent financial planner.
How to evaluate your stock options
Equity compensation provides a great upside, but it also introduces a major decision you must make – when to sell. If you are in need of cash, you can sell RSUs as soon as they vest with minimal tax consequence. For example, if the vested value is $10,000, the entire amount is taxed as ordinary income. If your employer applies a 30% withholding for taxes, selling the remaining $7,000 immediately generally incurs no further tax.
Similarly with NSOs, if the bargain element at exercise is $10,000, the entire amount is taxed as ordinary income. Again, a 30% tax withholding by your company means that selling the remaining $7,000 immediately generally incurs no additional tax.
If you believe in the growth potential of your company, you can hold onto shares rather than selling them immediately. While holding company stock offers the possibility of significant gains, it’s important to balance the potential rewards and the risks associated with maintaining a concentrated position in a single stock.
Financial planners typically recommend limiting a single stock to no more than 10%, but this number can vary depending on your risk level and personal situation. When evaluating your concentration, remember to look at not just your salary and vested company stock, but also your unvested equity and future salary.
A diversified portfolio of stocks and bonds using low-cost funds is generally good investing practice. For instance, suppose you’ve saved $100,000 in cash, along with $100,000 in company stock, and expect $20,000 of RSUs to vest each year. This represents that half of your savings is in your company stock and you may be taking an uncomfortable amount of risk.
A reasonable approach to diversifying this portfolio could involve a combination of actions. First, invest $60,000 of cash in a diversified portfolio, while setting aside $40,000 as emergency savings, equivalent to 3-12 months of expenses. Next, diversify the new vest of RSUs, leveraging the fact that selling them upon vesting incurs minimal tax consequences. Lastly, sell $20,000 worth of the company stock and reinvest the proceeds into the diversified portfolio.
After implementing the proposed strategy, the portfolio allocation would be:
Cash: $40,000
Diversified portfolio: $100,000
Company stock: $80,000
Continue the immediate sale of newly vested RSUs and the sale of a portion of the company stock until your position in the company stock is a comfortable share of your net worth. Regular monitoring and adjustments may be necessary to adapt to changing market conditions and personal financial objectives.
Making tax-optimized sales
There are multiple ways to diversify your portfolio, but some are more tax-efficient than others. When selling RSUs, selling shares that vested at a higher price than the current market value may result in a tax benefit in the form of a capital loss.
For RSUs with a gain, first determine if your country taxes capital gains, and whether the capital gains tax rates vary based on the duration you’ve held the assets. Regardless of the capital gains rules for your country, it’s essential to note that the value of RSUs is taxed as ordinary income in the year they vest, regardless of whether you sell or retain the shares.
Unlike RSUs that vest according to a predetermined schedule, you have control over when to exercise NSOs, allowing you to manage when you pay income tax on the bargain element. Similar to RSUs, determine if your country taxes capital gains, and whether the capital gains tax rates vary based on the duration that you’ve held the assets. It’s important to note that the bargain element of NSOs is taxed as ordinary income in most countries in the year of exercise, regardless of whether you sell or retain the shares.
Final thoughts
Equity compensation can be an incredible benefit that aligns your success with that of the company. However, managing multiple types or significant amounts can introduce complexity. If you don’t feel comfortable navigating taxes and stocks, or don’t have the capacity to give it attention, there is no shame in hiring an accountant or fiduciary financial planner specializing in equity compensation. Take time to conduct thorough research and seek expert guidance where necessary, so you confidently participate, manage risks, minimize taxes, and ultimately enhance your wealth through equity compensation.
Author’s note: This material has been prepared for informational purposes. If you are seeking more specific financial advice, it is best to consult a tax, legal, and accounting advisor who can provide guidance on your unique situation.
