An Old Folktale and Equity Compensation
I always enjoyed story time as a kid. Stories seemed to have a way of making concepts more memorable while simplifying the complex. In an attempt to channel my first-grade teacher, Mrs. Polly, we’ll try to simplify the world of equity compensation by enlisting the help of our friends, the Three Little Pigs.
Many companies include equity compensation as part of an employee’s overall compensation package. These companies can range from tech startups to large, publicly traded organizations. Headlines often focus on employees who became millionaires after an IPO or acquisition, but they rarely explain that “company stock” can come in several very different forms.
In our story today, the Three Little Pigs’ houses will represent three common types of equity compensation: Employee Stock Purchase Plans (ESPPs), Stock Options, and Restricted Stock Units (RSUs).
The Straw House: Stock Options
The straw house is inexpensive to build, but it’s also the most vulnerable. Stock options share some of those same characteristics.
A stock option gives you the right, but not the obligation, to purchase company stock at a predetermined price (called the exercise price) at a specified time in the future. Stock options can be very lucrative if the stock price rises. You’ve locked in a lower purchase price and may realize immediate gains when you exercise your options. However, if the stock falters, your stock options can expire worthless. Bad news, missed earnings or an external shock can wipe out all the value of your options.
It’s also worth noting that the tax treatment of stock options can be varied and complex. Factors such as the type of option and your holding period can have a significant impact on your tax return.
The Stock House: Employee Stock Purchase Plans (ESPPs)
Think of an Employee Stock Purchase Plan as the house made of sticks. It’s relatively straightforward, requires a little more effort and investment, and offers a bit more stability.
With an ESPP, employees use after-tax dollars to purchase company stock directly, often at a discount to the current market price. Generally, ESPPs allow employees to purchase stock during designated offering periods throughout the year. Shares purchased through an ESPP may also be subject to holding period requirements. Some plans allow employees to sell shares immediately after purchase, while others require the shares to be held for several months, or even for up to a year.
For many employees, an ESPP can be one of the simplest and most effective ways to participate in the growth of their company. However, it’s important to understand the plan’s rules and restrictions surrounding when shares can be purchased and sold.
The Brick House: Restricted Stock Units (RSUs)
The brick house represents the most durable and dependable structure, much like Restricted Stock Units.
With RSUs, employees receive company shares as compensation once certain vesting requirements, typically based on continued employment or the passage of time, have been satisfied. Unlike stock options, RSUs retain value as long as the underlying stock has value, making them a generally more predictable form of equity compensation.
That doesn’t mean they’re simple. When RSUs vest, the value of the shares is typically treated as ordinary income. From there, employees must decide whether to continue holding the shares or diversify into other investments.
RSUs are a stable form of equity compensation, but they still require thoughtful tax and investment planning.
The Big Bad Wolf: Concentration Risk
If you’ve read this far and haven’t grown tired of the Three Little Pigs analogy, I’ll make one final connection to the story. The Big Bad Wolf is the villain — the one determined to wreck the carefully laid plans of the pigs.
When it comes to equity compensation, the villain is often overconcentration in a single stock or company. As much as you may love the company you work for, the risk of disappointing news or increased competition is always present. One big huff and puff of bad news can have a significant impact on your overall net worth if too much of your wealth is tied to a single company’s stock.
At P&A, we’ve championed the benefits of diversification since our founding. In fact, Jon wrote an article on the topic back in 2015, and the principles remain just as relevant today as they were more than a decade ago. You can revisit it here.
Bringing It All Together
Employee equity compensation can be an outstanding wealth-building opportunity, but each type comes with its own rules, risks, tax consequences, and planning opportunities.
Whether you’re deciding how much to contribute to an ESPP, when to exercise stock options, or what to do with newly vested RSUs, those decisions shouldn’t be made in isolation. The right approach isn’t simply about choosing the strongest “house.” It’s about building a financial plan that’s right for you and helps you navigate whatever life brings.
If you’ve recently received equity compensation, or expect to in the future, give our team at P&A a call. We’d be happy to help you make sense of it all.
Clicking on the links above may result in you leaving the Pittenger & Anderson, Inc. website. The opinions and ideas expressed on these external websites are those of third-party vendors and Pittenger & Anderson, Inc. has not approved or endorsed any of this third-party content. For the full Terms & Conditions of using the Pittenger & Anderson, Inc. website, click on this link.
Pittenger & Anderson, Inc. makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss.
Pittenger & Anderson, Inc. does not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction. Additionally, the information presented here is not intended to be a recommendation to buy or sell any specific security. To learn more about our firm and investment approach, check out our Form ADV.
To view this article and others like it online, visit the P&A blog at https://pittand.com/blog/.
Click here to download the PDF version of this article.
