When many people consider the compensation package for an employer, they primarily look at the base pay and possible bonus potential. Beyond that, other fringe benefits such as health insurance, company paid life insurance, a 401(k) match, or other perks (like being able to work from home) may come into the equation. However, for many people who work for publicly traded companies, a portion (often significant) of their total compensation will come in some form of company stock awards. How do you quantify this part of your pay, and its risks, when evaluating your entire compensation package? Here are some things to consider when company stock is a portion of your total pay.
While there are certainly reasons to work besides cashing a paycheck (social interaction, personal enjoyment, to keep busy, etc.) most people wake up and drag themselves to the office (or their home office) to get paid. Unless you are paid entirely on commission, most jobs will come with some form of base pay. This income can be relied upon so long as you remain employed and the company is solvent.
Obviously the higher this number is, the more “guaranteed” pay you can expect each week, month, and year. Since this pay is guaranteed, there is little risk to you and more risk to the company to keep you on the books. You, as a hopefully productive and useful employee, are a direct cost to the company, but your work provides more value than what the company spends paying you. This way they continue to pay you for your services.
This guarantee is what makes the salary number so valuable to potential employees. However, to sweeten the pot, many companies will also offer some form of variable component in addition to a base salary.
Variable pay flips the script on the risk-reward ratio. This form of compensation is more risky to the employee, and less to the company. Since this pay is not guaranteed and is usually based on some form of performance metrics, a company may not need to pay out this money assisting their cash flow in times of stress or rewarding employees directly related to the additional value provided.
Commissions are a good example of a direct form of variable pay. You don’t sell, you don’t get paid. The company makes more selling the product to the consumer than they do paying the employee a commission.
In this model there is little risk to the company (maybe a small base salary and a little overhead) limiting their fixed costs. While the risk to the employee is larger, the opportunity to make significantly more money is substantial. Their ability to earn income is only limited to how much they’re able to sell. The more they sell, the more they earn, and it’s not capped by a base salary amount.
Typical Forms of Variable Pay
Like people, variable pay can come in all shapes and sizes. As discussed above, commissions are a common form of variable pay. Another typical example is an annual or quarterly bonus based on company performance and cash flow. In lieu of a direct payment into your check, a company may instead offer a profit-sharing program putting additional money from the company directly into your 401k.
One of the trickiest forms of variable compensation can come in the form of company stock. There are many different types of stock plans and each work a little different. To complicate things further, depending on the type of plan, some may have some “base” pay qualities as well. Some examples of the different stock plans are:
- Restricted Stock Units (RSUs)
- Employee Stock Purchase Plan (ESPP)
- Nonqualified Stock Options (NQSOs)
- Incentive Stock Options (ISOs)
When evaluating your total compensation package, it’s important to understand the risk and rewards of your entire pay structure, including stock plans. Many smaller companies may not be able to offer a higher salary or better benefits, but what they may be able to offer is more potential, in the form of company stock. Understanding the pay and benefits you may forego from one job when considering another is important when evaluating your entire benefits package.
Restricted Stock Units (RSUs):
Restricted stock units are a common form of compensation that a company may offer in addition to base salary and benefits. You receive a certain number of shares on various vesting dates. It’s common to have vesting periods 1,2,3, or 4 years out and you can have various “lots” vest at the same time.
If you leave the company before the vesting date you don’t receive those shares. But if you’re still with the company on the vesting date you receive the shares on that date. You are taxed on the value of the shares that vested, and sometimes some shares are automatically sold pay taxes.
Ex: Mary was granted 200 shares of XYZ company on 6/30/21 with 50 shares vesting on the same date in 2022, 2023, 2024, and 2025. On 6/30/22 XYZ company was valued at $10 a share, so she will owe taxes on $500 worth of income (50 * 10).
Once the shares vest you own them. At that time, you are generally free to sell the shares or continue to hold them as an investment.
Risks and Rewards:
There are several risks associated with RSUs as compensation. First, if you are not employed by the company on the vesting date, you don’t receive any shares. You forego that benefit when you leave the company. Second, because the compensation is valued in shares and not dollars, the amount of money you receive will be variable based on how well the company stock is doing at the time. If we take the same example as above, and instead of trading at $10 a share, the stock is trading at $100. The amount she would include in taxable income is $5,000 instead of $500.
Once you receive the stock, you need to decide whether to sell it now (at a minimal capital gain/loss, taxed at ordinary income tax rates) or hold it for at least a year so the tax rates will (generally) be the lower long-term capital gain rates. However, by holding the stock for the year, the price may fall and you may incur a loss, defeating the purpose of waiting to sell. In addition, if your income is tied up in your company, do you really want your net worth (stock) there as well?
Note that your tax basis (cost) is the value of the stock the day the restrictions were removed and you were able to access it (generally, the vesting date).
Understanding how stock market volatility can impact your stock plan stock is crucial to managing your plan effectively.
Employee Stock Purchase Plan (ESPP):
Another common company stock benefit is the employee stock purchase plan (ESPP). With this benefit you withhold money from your paycheck each week and put it toward buying company stock at specified periods, similar to having money withheld to put into your 401k.
The best of these plans allow you to purchase stock at up to a 15% discount, allowing you to pocket a capital gain right away. In addition to that, the plan often has an anchor price, which can be the beginning of the purchase period, the end of the purchase period, or the more preferable of the two.
Ex: Joey participates in his company’s ESPP plan. The plan offers a 15% discount and will use the better price at either the beginning or the end of the contribution period. On January 1st ABC company is trading at $15 a share. He contributes to the plan until June 30th and puts $1,000 toward the plan. On June 30th the stock is trading at $25 a share. Since his plan allows him to purchase at the lowest price, and at a 15% discount, Joey purchases the shares at $12.75 ($15 * 85%) even though the stock is currently trading much higher!
The tax consequences of this transaction are complicated and beyond the scope of this blog. In general, the longer you hold the stock, the better the tax consequences but the greater the investment risk, as the stock price fluctuates with the market.
Risks and Rewards:
When evaluating your total compensation, it’s crucial to look very closely at the ESPP plan because not all plans are created equal. In some cases, the ESPP plan is structured more as a marketing ploy than an actual employee benefit. A good example of this would be an ESPP plan that does not offer any sort of discount on the purchase. If you are not getting a discount, you probably shouldn’t be participating in the plan because you could buy the shares for the same price on the stock market (although we would recommend investing in a more diversified investment instead!).
Another key consideration is how long you must hold the shares. Some plans require shares purchased to be held for a certain period of time before they can be sold. If this is the case, you need to weigh the benefits of the discount against the market risk of holding the shares. If your plan only offers a 5% discount and you have to hold the shares for 3 months, there is a chance that the discount could evaporate by the time you are able to sell. Alternatively, if you are receiving the full 15% discount, can sell any time, and they use the most preferable price, your market risk is significantly less.
The key lesson here is to review what sort of discount you receive and the flexibility of the plan itself. If it is not generous, or has a strict selling policy, it may be better to not consider this benefit as a form of compensation when evaluating your total compensation package.
Stock Options - Both Non-Qualified (NQSO) and Incentive Stock Options (ISO):
The last stock plan we will review are stock options. The difference between NQSOs and ISOs are the possible tax implications of the plan. Incentive Stock Options have potential preferential tax benefits associated with them, and are a little more uncommon today, so we will not discuss the specifics of them here. In either case, a stock option allows the employee to purchase the company stock at a predetermined price, regardless of the current value of the stock. This is true for both ISOs and NQSOs.
Ex: Laura works for XYZ company and has an option to buy 100 shares of the company at $100 a share. Currently XYZ company is trading at $75 a share. One year later, the stock jumps in value and is trading at $150 a share. Laura decides to exercise her option and buy the shares at $100 even though the stock is trading much higher.
For NQSOs, like with ESPP plans, the discount between what you buy the shares for and where they are currently valued is taxed to you as income. If you sell the shares shortly after exercising there is typically only a small additional gain/loss and will have only a marginal additional impact on your tax return.
Risks and Rewards:
When evaluating stock options as part of your compensation package these should be considered entirely variable pay. Earning any money on these options is not guaranteed, but the potential benefit can be massive if the stock does well. This is because there is no promise that the options will ever be worth anything.
If we take the example from before, if XYZ company never traded above $100, it would never make sense for Laura to exercise the option because she could buy the stock more cheaply in the open market. Although she received the stock option as a benefit, she never actually received any additional compensation from it, and thus, also never incurred any additional taxes. Alternatively, the stock could have jumped much higher than the $150 in the example. If the stock was at $500, she just made it big!
Another consideration with stock options is that they have a limited shelf life. Meaning, they don’t last forever, and you cannot necessarily wait until the stock is above the exercise price before you use it. As an example, an option might only last for 2 years. During the full two years you can buy the stock at the option price, but after that period, you no longer can use that stock option . . . it goes away forever.
The big considerations with stock options are how many shares are you granted, at what price, where is the stock trading now, how long are the options for, and how do you believe the company will perform in the future. Better plans will obviously offer more shares, at a lower price, and allow you a long time to decide whether you will exercise them or not.
Many smaller companies offer stock options as part of their compensation package because of this risk-reward trade off. They do not have to offer a higher base salary now, helping their cash flow. But, if the company does well, the employee gets to benefit from the substantial growth and the company only needs to provide shares, not additional cash.
Out of the three stock plans stock options are the riskiest for the employee but may provide the greatest benefit if things go well. Understanding the risk of the options as part of your compensation package is key to evaluating whether to take a job or not. The base salary may be lower, but with that trade off, there may be a higher potential for total variable pay if things go well.
Long gone are the days where compensation packages consisted of only a salary, a possible year-end bonus, and a 401(k) match. Nowadays, many employers are offering more complex compensation plans that include some form of stock along with various perks and benefits that must be weighed against each other. Not to mention, when you add a spouse to the mix, comparing their benefits to your own and which should be chosen between the two companies.
When comparing complex benefits, and understanding the risks and rewards of them, it is often a good idea to enlist the help of a competent financial professional. If you need assistance reviewing your compensation arrangement, or just your financial plan in general, we encourage you to reach out to our team.
Nick Prigitano, CFP® is an advisor at Milestone Financial Planning, LLC, a fee-only financial planning firm in Bedford NH. Milestone works with clients on a long-term, ongoing basis. Our fees are based on the assets that we manage and may include an annual financial planning subscription fee. Clients receive financial planning, tax planning, retirement planning, and investment management services, and have unlimited access to our advisors. We receive no commissions or referral fees. We put our clients’ interests first. If you need assistance with your investments or financial planning, please reach out to one of our fee-only advisors.