What Is Stock Compensation? (With Types and an Example)
By Indeed Editorial Team
Published April 2, 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Stock compensation is a way for employers to reward employees in the form of stocks, performance shares or stock options as an alternative or supplement to paying them in cash. Companies often use stock compensation to encourage employee retention, motivation and performance. Understanding how stock compensation works can help you make an educated decision about the benefits you want to receive from employers. In this article, we define stock compensation, describe how it works, list types of stock compensation and offer an example of an employee attaining stock compensation.
What is stock compensation?
Stock compensation is a method companies use to reward employees. Instead of simply offering cash, companies offer employees stock or stock options, meaning they gain partial ownership of the company and share in its profits. Smaller companies and startups often use this method as they may be unable to pay employees at a competitive rate before generating a certain level of profits. Stock compensation can be a useful way to encourage productivity in a company because an employee's success can directly increase the value of their stocks.
How does stock compensation work?
Stock compensation is often subject to vesting before a company offers it to an employee, meaning that employees' options to exercise their stock compensation differ depending on how long they've owned the stocks. For example, an employee given 900 shares of a company that vest annually over a period of three years might be able to exercise 300 shares the one year, followed by 300 the next and so on.
Companies often use vesting to encourage employees to stay at a company for a longer period of time, and if an employee leaves their position during the vesting period, they typically forfeit their unvested shares. Throughout a vesting process, employees purchase a certain number of shares at a set price. The decision when to vest depends on several factors, such as the time of year or whether they're meeting individual performance targets. After vesting, employees can exercise their stock options at any time they want before the expiration date, which is often 10 years.
Types of stock compensation
Some companies base their stock compensation on specific performance metrics while others may offer certain tax advantages. Each type of stock compensation has its own advantages and considerations. Here are the different types of stock compensation a company may offer employees:
With stock options, companies allow employees to purchase shares of the companies' stocks at a predetermined price, also known as the strike or exercise price, for a set number of years. Stock options often require employees to remain with the company during vesting before they can exercise the options. When the option vests, the employee receives the full right to sell the option if they choose.
Stock options don't offer employees the same rights as shareholders but may offer certain advantages. For example, if the company is financially performing well, the exercise price might be lower than its fair market value, meaning the employee can buy the stock at a lower price and sell at a higher price, providing significant financial benefit depending on how quickly the stock price rises. Stock options may also offer tax benefits and ease the process of starting a savings plan.
Non-qualified stock options (NSOs)
A non-qualified stock option (NSO) is a stock option that requires the payment of income tax on the exercise price, or the price paid to the company per share, subtracted by the price of the exercised option. They also offer the tax advantage of not having to report when the option becomes exercisable. These stock options have a price similar to the market value of the shares when the company makes them available. While employees still have to pay income tax, they may be able to acquire the stock at a significant discount.
Some companies may have clawback provisions, which are provisions that allow the company to reclaim the NSO for a certain reason, such as in the case of a buyout or bankruptcy. In some cases, a company may also use a clawback when an employee leaves the company before a predetermined date. This can prevent an employee from leaving a company prematurely.
Incentive stock options (ISOs)
An incentive stock option (ISO) is a special stock option that's only available to employees and provides them with certain tax advantages, such as preventing the employee from having to pay taxes on the shares when purchasing them. It may also qualify employees for a lower tax rate, reducing their overall burden because the government typically taxes them at a capital gains rate, rather than the rate for ordinary income. Companies normally award this type of stock compensation to high-performing employees the company wants to retain long term.
Publicly traded companies most often offer ISOs, as well as privately owned companies that are planning on becoming public in the future. This can be a way to attract talented professionals, which is similar to other benefits, and can be a powerful incentive for high-performing employees. Like an NSO, ISOs may be subject to clawback provisions and require employees to hold the stock for longer than a year in order to qualify for a decreased tax rate.
Performance shares are special shares that a company may award to corporate managers and executives if they meet certain performance criteria. Companies often offer performance shares in the form of stock options and bonuses in order to prioritize business activities that positively impact shareholder value and overall productivity. Managers often receive this type of compensation for meeting specific targets, such as earnings per share (EPS) or return on equity (ROI) targets.
Performance shares are often highly dependent on a company's performance. In some cases, a company may only issue performance shares if its stock meets or exceeds a certain value. Companies may also structure performance shares based on different accounting measures that measure how well the company is financially performing, such as cash flow or return on capital.
Restricted stock includes shares of a company's stock that require the completion of a vesting period. The company may require vesting in any way they find suitable. While the company restricts the employee from selling the stock, they may enjoy the benefits of the stock ownership, such as dividends. Like other stock compensation, the employee forfeits their right to the stock if they leave the company prematurely. Employees pay taxes on the number of shares received on the vesting date, based on the stock's closing market value.
Restricted stock units (RSUs)
A restricted stock unit (RSU) is a company's promise to pay a certain number of shares based on a vesting schedule. RSUs make it easier for a company to avoid diluting its share base and lower administrative costs because the company hasn't yet issued the shares to employees. After vesting, an employee gains the rights of stock ownership, such as voting rights. For tax purposes, the entire value of an employee's stock counts as ordinary income on the vesting date, or when the stocks become transferable.
Read more: How Do RSUs Work? (With Example)
Example of stock compensation
Here's an example of stock compensation that you can reference when gauging your company's offerings:
Dan works at a company called Adam's Appliance Corporation, which has just granted him the option to purchase 1,000 shares in the company at $40 per share. The company has established a multi-year vesting schedule for five years, so Dan can exercise the first 200 shares in the first year, meaning he can purchase and sell the stocks included in the option. In the first year, the company experiences impressive financial growth, and the value of the company's stock rises to $80. Dan then purchases the 200 shares at $40, or for $8,000.
Dan then sells those same stocks on the market for $16,000, or 200 shares at the value of $80. Dan gained $8,000 in profit when the value of the stock doubled. The next year, Dan can exercise the options again and so forth until he eventually reaches his 1,000 shares.
Disclaimer: This article is for information purposes only and is not intended to constitute legal advice; you should consult with an attorney for any legal issues you may be experiencing.
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