Stock Compensation Explained: What It Is, How It Works, Types, and Examples


Stock compensation is a method employed by corporations to reward their employees with stock or stock options instead of cash. These compensation plans often come with vesting periods, which can last three to four years, commencing after the first anniversary of an employee’s eligibility. Two primary types of stock compensation are non-qualified stock options (NSOs) and incentive stock options (ISOs). Additionally, some companies use performance shares to incentivize managers and executives based on specific performance metrics. Understanding how stock compensation works is essential for employees, as it plays a crucial role in their financial well-being.

What is stock compensation?

Stock compensation is a method corporations utilize to reward employees, offering them stock or stock options as an alternative to traditional cash compensation. This approach aligns the interests of employees with the company’s performance and growth. However, it’s crucial for employees to understand the intricacies of stock compensation, especially when it comes to vesting and tax implications.

How stock compensation works

Stock compensation is particularly prevalent among startup companies that might not have the financial resources to offer competitive cash salaries to their employees. It allows employees, including executives and staff, to share in the company’s growth and financial success. However, this practice comes with various legal and compliance considerations, including fiduciary duty, tax treatment, deductibility, and regulatory obligations.

When it comes to vesting, companies usually grant employees the right to purchase a predetermined number of shares at a fixed price. Vesting can occur on specific dates or follow a scheduled pattern, which may be linked to company-wide or individual performance targets. Vesting periods often span three to four years, usually beginning after the first anniversary of an employee’s eligibility for stock compensation. Once vested, employees can exercise their stock-purchasing option anytime before the option’s expiration date.

Example of stock compensation

Let’s consider an example to illustrate how stock compensation works:

Imagine an employee is granted the right to purchase 2,000 shares of stock at $20 per share. The stock options vest at a rate of 30% per year over three years, and the options have a five-year term. Regardless of the stock’s current market price, the employee can purchase shares at $20 each over the five-year period.

Types of stock compensation

There are several types of stock compensation, including:

Non-qualified stock options (NSOs):

NSOs are available to both employees and non-employee directors or consultants. However, these options come with specific tax implications, and employees must pay income tax based on the grant price minus the exercised option price.

Incentive stock options (ISOs):

ISOs are exclusively available to employees and offer certain tax advantages. They often come with more favorable tax treatment compared to NSOs.

Stock appreciation rights (SARs):

SARs allow the value of a predetermined number of shares to be paid in cash or shares.

Phantom stock:

Phantom stock provides a cash bonus at a later date equivalent to the value of a set number of shares.

Employee stock purchase plans (ESPPs):

ESPPs enable employees to purchase company shares at a discounted price.

Restricted stock

Restricted stock and restricted stock units (RSUs) are forms of stock compensation that involve employees receiving shares after working a specific number of years and meeting predefined performance goals. Vesting requirements may vary, with options for immediate or gradual vesting based on management’s decisions.

RSUs operate in a similar fashion, with the promise of shares to be issued according to a vesting schedule. However, RSUs do not grant employees ownership rights, such as voting privileges, until the shares are earned and distributed.

Performance shares

Companies may award performance shares to executives and managers if they meet specified performance criteria. These criteria often include metrics like earnings per share (EPS), return on equity (ROE), or the total return of the company’s stock in comparison to a relevant market index. Performance share programs typically span multiple years to assess long-term performance accurately.

Exercising stock options

Exercising stock options can be done through various methods, including:

  • Cash payment
  • Exchanging shares already owned
  • Collaborating with a stockbroker for a same-day sale
  • Executing a sell-to-cover transaction

However, it’s important to note that companies often restrict the methods available for exercising stock options. Private companies, for instance, may limit the sale of acquired shares until the company goes public or is sold. Additionally, they may not offer sell-to-cover or same-day sales as options.

Weigh the risks and benefits

Here is a list of the benefits and drawbacks to consider.

  • Potential for financial gain if the company’s stock value increases
  • Alignment of employee interests with company performance
  • Tax advantages for certain stock compensation types
  • Risk of stock value decline impacting compensation value
  • Complex tax implications
  • Limited liquidity until options are exercised

Frequently asked questions

What is the purpose of stock compensation?

Stock compensation serves as a tool for companies to reward employees and align their interests with the company’s performance and growth. It can also help companies conserve cash, which is especially valuable for startups.

How do vesting periods work?

Vesting periods are predetermined timeframes during which employees must wait before they can fully access their stock compensation. This typically ranges from three to four years and often begins after the first anniversary of an employee’s eligibility.

What are the tax implications of stock compensation?

The tax implications of stock compensation vary depending on the type of compensation and the employee’s individual circumstances. It’s essential to consult with a tax advisor to understand and manage these implications effectively.

What is the significance of a vesting period in stock compensation?

Vesting periods play a crucial role in stock compensation by ensuring that employees remain committed to the company for a specified period. During this time, employees must meet certain conditions, such as continued employment or achieving performance goals, to gain full ownership of their granted shares. Vesting helps companies retain talent and incentivizes employees to contribute to the organization’s success.

How does taxation work with stock compensation?

The taxation of stock compensation can be complex and varies depending on the type of compensation and individual circumstances. Generally, when employees exercise stock options, they may be subject to ordinary income tax on the difference between the option’s grant price and the market price at the time of exercise. It’s important to consult with a tax advisor to understand the tax implications specific to your situation.

Are there any risks associated with stock compensation?

While stock compensation offers the potential for financial gain, it also comes with risks. Employees who hold stock options face the risk of a decline in the company’s stock value, which can affect the value of their compensation. Additionally, there may be limited liquidity until options are exercised, meaning that employees might not have immediate access to cash from their stock holdings. It’s important to carefully evaluate these risks when considering stock compensation.

Key takeaways

  • Stock compensation is a common practice used by companies to reward employees with stock or stock options.
  • Vesting periods are a typical feature of stock compensation, often lasting three to four years.
  • There are different types of stock compensation, including non-qualified stock options (NSOs) and incentive stock options (ISOs).
  • Performance shares may be awarded to executives based on specific performance metrics.
  • Exercising stock options can be done in various ways, but the available methods may be restricted by the company.
View article sources
  1. Understanding Stock-Based Compensation – Harvard Business School
  2. Stock Compensation: The Most Expensive Way to Pay – Southern Methodist University
  3. Stock-based Compensation – U.S. Securities and Exchange Commission
  4. Equity Stock Based Compensation Audit Techniques Guide – Internal Revenue Service
  5. Equity Compensation Demystified: Unlocking Employee – SuperMoney