Your Guide to Equity Compensation at Public Companies
It’s probably best we start with the basics…
What is equity compensation?
Equity compensation represents a form of ownership in the company. Ownership can come in a variety of different forms, but for today's sake we’re going to focus on one in particular. Restricted Stock Units, or more commonly known as RSU’s. The main reasons why you see public companies offering RSU’s to new and existing employees are:
It’s a great way to attract top tier talent
It’s a great way to KEEP top tier talent
What better way to get everyone aligned to one common goal of ensuring the long term success of the company than giving the employees, not just company executives, a piece of the pie? The harder everyone works, in theory, the higher the value of everyone's equity down the road.
A lot like your 401k might work, equity compensation typically comes with a vesting schedule or a time constraint before you get full access to your equity. RSU’s typically come with a 4 year vesting period with a 1 year cliff and quarterly or monthly vests. For example, the company might grant you $100,000 worth of RSU’s when you start at $10/share (or 10,000 shares in total) with 25% of them vesting at the end of year 1 (2,500 shares) then every month or quarter there after a smaller portion of them will vest until the end of the 4 year period where all 10,000 RSU’s would be fully vested. Every company will differ slightly here, but you get the picture.
Taxes (sigh…)
RSU’s in particular are taxed as ordinary income in the year in which they vest, regardless of when you actually sell them. Even though this comes with a significant tax bill immediately, RSU’s actually offer the most flexibility for employees because they are relatively simple in how they work. They’re taxed as any normal bonus would be taxed so anything under $1MM, the company will automatically withhold 22% of the value to pay the tax bill and anything over $1MM, the company will withhold 37% for taxes. The only issue is, in most cases the automatic withholding doesn’t actually cover enough of the tax bill so it’s imperative that you model out all of your equity grants over time, combine it with your normal salary and run tax projections throughout the year so you don’t get hit with underpayment penalties by the IRS. When you get a good grasp on what your tax bill will actually be throughout the year, you can make estimated tax payments every quarter by April 15th, June 15th, September 15th and January 15th of the following year to avoid these penalties.
RSU’s come with a 2nd tax hit as well in the form of Capital Gains. This means you’ll also pay taxes on the difference between the value of the RSU’s when they were exercised (using the previous example of 10,000 shares at a $10 stock price or $100,000) and the value of the shares when you sell them (say the stock price was $20/share) or a gain of $100,000 ($200,000 at sale minus $100,000 at exercise). If you sell them within 1 year of exercise, they’ll be taxed at ordinary income rates, but if you sell them more than 1 year after exercise, they’ll be taxed at lower, more favorable long term capital gains rates (0%, 15% or 20% depending on income). Depending on your situation, it may or may not be favorable to actually hold them for that extra year-long period simply to get favorable tax treatment. You always risk the price of the stock tanking immediately after exercise, sticking you with a massive tax bill when your actual proceeds are worth far less.
Main Points
At public companies, equity compensation is a significant benefit to employees because there is always a public market to sell into. Although you’ll most likely be subject to specific trading windows throughout the year, you’ll have liquidity that those at private companies don’t have.
The initial grant you receive at the company will also most likely be the largest grant you get so when making the decision to stay at the company or seek employment elsewhere, it becomes a lot easier to do once that initial tranche of RSU’s vest. You can always leverage the shares you forfeit when you leave the company when negotiating the amount of equity your next company gives you when you join.
This can be life changing money for most tech employees so having a game plan for how to sell, when to sell, how much pay in estimated taxes throughout the year and what to do with the proceeds afterwards to maximize the potential of achieving your goals is imperative.