Become a better investor
Lesson in Course: Finance at work (beginner, 4min )
What are the different ways companies can pay us with equity?
When companies grant equity, we typically receive the shares over a period of time or when we hit a particular performance milestone. There are a few ways companies can give equity to us.
Understanding the difference helps us know if we have to pay for the stock or not. As we'll see in other lessons, significant tax implications and strategies vary depending on the type of stock reward.
Stock options are the most common. A stock option is a contract that gives us the right, but no obligation, to buy stock in the company at a predetermined price. Being granted stock options doesn't actually give us the stock; we own the shares once we've exercised the option.
Even though this means that we'd have to pay money out of our own pocket to finally own the shares, we don't have to buy them if we don't want to. We can decide to walk away.
Restricted stock awards are shares that we can purchase. However, the price we pay and when we can buy the shares makes them different from options.
We "own" the shares when granted to us, but we still may have to purchase them. We can buy all of them on the date they're given, and the price we pay for them might vary - at the fair market value, a discount, or no cost.
However, most companies will have restrictions that allow them to repurchase the shares if we leave the company within a certain period of time.
Unlike RSAs, restricted stock units are shares that we will own at a future date. When granted RSUs, the company promises to give us stock if we meet a set condition.
The requirement could be to work at the company for a certain amount of time or reach a performance goal. Consequently, we don't receive stock if we fail to meet the conditions.
The most significant difference with RSUs is that we don't have to pay anything to receive them once we meet the conditions. As a result, there are some tax implications to be aware of when we receive RSUs.
Our employers will choose which type of equity compensation to use based on various advantages. In most cases, employers will change their offering as they grow.
Companies in their infant stages typically issue RSAs to founders and initial hires when it's tough to afford competitive salaries. RSAs are more attractive to us because we end up getting a piece of the pie that turns into a major reward when the company succeeds.
As start-ups grow into early-stage companies, it makes more sense to issue stock options. We get less upside than RSAs; however, the cost to exercise the shares is still affordable.
Once companies mature and are successful, they usually issue RSUs since exercising stock options becomes too expensive for most employees. The growth of the company has also slowed, making it harder for the options to be valuable.
Knowing the type of equity compensation we've received is the first step in unlocking the potential we've been granted. The next step is to maximize the benefit by minimizing the taxes we have to pay. Take a look at the lesson about the taxes owed to sell stock options and RSA and RSU tax strategies for more.
A form of equity compensation - shares of a company that an employee can purchase on the grant date but can be repurchased by the company if certain conditions aren't met, such as time at the company or performance
A form of equity compensation - shares of a company that an employee receives when they meet certain conditions, such as time at the company or performance