Types of Stock Compensation
Employee stock equity compensation is offered in a variety of forms and plans. Examples include stock options, restricted stock units (RSUs), employee stock purchase plans (ESPPs), and more. The following five types are explained below.
Stock Options: Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs)
Restricted Stock Units (RSUs)
Stock Appreciation Rights (SARs) and Phantom Stock
Performance Stock
Employee Stock Purchase Plans (ESPPs)
The functionality of each type is explained in the next section.
How Does Stock Compensation Work?
Stock compensation works by offering employees stock options as compensation. To acquire the shares outright, they must remain employed by the company for a specific period. There are many types of stock options, each with its own characteristics.
- Stock Options:
A stock option is a common form of stock compensation. It grants employees the right, but not the obligation, to purchase company shares at an initially agreed-upon price (the exercise price) after a subscription period. The acquisition of subscription rights includes full ownership. With stock options, the value of the allocation depends on the share price performance relative to the exercise price.
There are two main types of stock options: Individual Stock Options (ISOs) and Non-Exempt Stock Options (NSOs). ISOs offer tax advantages because a favorable Capital Gains Tax (CGT) is only levied upon the sale of the shares, at the earliest two years after the allocation date and at the latest one year after the exercise date. (Note: Alternative Minimum Tax (AMT) may apply when exercising your ISOs.) With NSOs, you may be liable for tax upon exercise and sale.
- Restricted Stock Units (RSUs): Restricted Stock Units are a lower-risk form of stock compensation because they are typically allocated free of charge. This means you don’t have to exercise your right to purchase the shares. You will receive the full value of the shares once the subscription rights have been fulfilled.
Your Restricted Stock Units (RSUs) may be subject to tax upon purchase and sale.
- SARs and Phantom Shares: SARs and phantom shares are a form of employee participation that rewards employees—without the use of shares—with compensation linked to share performance. Participants are therefore not shareholders and have no voting rights.
Your compensation depends on the increase in the share price or the total value of the shares. After the (usually limited) subscription period expires, you will receive either a cash payment or (less commonly) the actual shares.
Taxes may apply when you exercise and sell your compensation.
- Performance Shares: Performance shares are awarded when employees achieve certain performance-related targets. This compensation is often given to executives and board members as an incentive for achieving specific performance goals.
- Employee Stock Purchase Programs (ESPPs): ESPPs are commonly used by publicly traded companies and allow participants to purchase company shares at a discount, often between 5% and 15% below fair market value.
This is achieved through contributions deducted directly from employees’ net pay over a specified period. The accumulated contributions are then used to purchase company shares on the purchase date.
With a non-qualified ESPP, you pay taxes on both the purchase and sale of your shares. With a qualified ESPP, you pay taxes only on the sale of your shares.
Potential Challenges with Employee Stock Ownership Plans
While stock-based compensation is popular across industries, its biggest drawback lies in its complexity.
Numerous reports and regulations, as well as applicable legal systems and tax laws, must be considered. Designing such a plan requires significant effort and careful planning.
Furthermore, it creates additional workload for your existing departments: from recording and reporting changes in ownership and updating documents, policies, and procedures to communicating with stakeholders, advising the board, and ensuring legal compliance.
Fortunately, there is a solution: J.P. Morgan Workplace’s automated stock management software.
Are you looking to implement a stock-based compensation plan? Contact us today. Thanks to our technology and team of stock experts, our stock management solutions handle all the complexity and effort involved in implementing your plan.
Our expert teams will guide you through the implementation process, assist you in designing and launching your plan, and provide ongoing maintenance and optimization even after launch. Our intuitive and automated stock-based compensation software allows company administrators and employees to view and manage their stock ownership 24/7—without any time-consuming training.
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Frequently Asked Questions about Employee Stock-Based Compensation
What is stock-based compensation?
Stock-based compensation, also known as equity-related compensation, is a form of benefit in kind that companies offer their employees to give them a stake in the company. Examples include stock options, restricted stock, stock appropriation rights (SARs), and employee stock purchase programs (ESPPs).
Why stock-based compensation?
The main advantage of stock-based compensation lies in the financial benefits for both employers and employees. Employers can offer their employees more, which benefits the employees, without impacting the company’s bottom line, which in turn benefits the employer.
How does stock-based compensation work?
With stock-based compensation, employees receive shares either directly upon joining the company or through an agreement that allows them to remain with the company for a specific period and thus acquire full ownership of the shares.
How many shares should employees be granted? Startups typically create employee stock ownership plans that represent between 10 and 20 percent of the company’s total equity (50 percent for the founders and between 30 and 40 percent for investors).