Different Equity Compensation Plans you should know as an Employee

There are 4 most common types of equity compensation that often got people confused…

…even when they have been working for a few years.

This post will clarify things once and for all. You are welcome 🙂

RSU (Restricted Stock Unit)

How it works

In this type of equity compensation, the Company grants you a specific number of shares at no cost, which will vest over a defined period.  However, you don’t own the shares yet at the time of grant. You only own the granted company shares at the time of vesting. For example, 25 percent of the granted shares will vest in a period of one year after the grant. Another 25 percent will vest two years after the grant and the last 25 percent will vest at 4 years after the grant. You, as the RSU holder, do not need to execute any market transaction.

Under relatively rare circumstances, vesting is subject to company or individual performance.

In short, RSU = deferred equity compensation, postponed to the vesting date, using the company’s stock as currency.

Purpose

Used to promote loyalty, retain talent and poach talent all the same. Granted based on current or past performance, regardless of future performance. Normally granted to exempt level to executive level staff.

Pros

1. Easier for employee to understand the vesting period on RSU compared to ESO.
2. As long as you remain hired, you will reap the benefits – it’s just a matter of time. No further action required unless one wants to sell the vested shares.
3. RSU do not become worthless like stock options unless company goes into bankruptcy or de listed. Even it stock price falls, RSU retains its intrinsic value.
4. Motivating employees to think like owners.

How you profit

Sell the vested shares immediately at market price. Note that the entire amount is subject to tax as they are treated as income.

Or sell the vested shares at a later date if you anticipate the stock price to appreciate.

RSA(Restricted Stock Award)

How it works

Similar to RSU equity compensation, with one significant difference – you own the shares at the time of grant. This is only relevant when it comes to taxation differences, which is beyond the scope of this post.

Company may also impose conditions that certain performance benchmarks and goals ought to be met in a certain fiscal year before the scheduled vesting takes place for the same time period.

Purpose

Employee retention and loyalty. Takes into account future performance. Grant is not unusual for executive level staff whose decision steer company vision and direction.

How you profit

Sell the vested shares immediately at market price. Note that the entire amount is subject to tax as they are treated as income.

Or sell the vested shares at a later date if you anticipate the stock price to appreciate.

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ESPP (Employee Stock Purchase Plan)

How it works

Employee voluntarily participates in an automatic monthly salary deduction plan (up to 10 percent of gross salary). The accumulated pay cheque deduction for, say, 6 months, will be used to purchase the company shares at a fair market price, less (up to) 15 percent discount at the end of the offering period. The definition of fair market price may differ slightly among companies – it could be the company stock price at the last trading day for the offering period or the lowest stock price between the the first and last trading day of the offering period.

Usually, an ESPP allows participants to withdraw from the plan before the 6 months offering period ends and have their accumulated funds returned to them. It is also common to allow participants who remain in the plan to change the rate of their payroll deductions as time goes on.

Purpose

It is akin of an investment using your own money with low to moderate risk of achieving a 15 percent ROI.

How to profit

Sell the shares (the earliest it allows you to) you purchased  under the plan for immediate capital gain.

Or, sell at a later date if you expect the stock price to appreciate further.

Note that the 15 percent discount is not considered as capital gain,but rather, as income. Therefore it is subject to tax. Capital gain, on the other hand, is not taxable in Malaysia.

Read my previous post on ESPP Part 2 –  Employee: 0, Government: 1.

ESO (Employee Stock Option)

How it works

The key term here for this last type of equity compensation is option and exercise (no, not physical activities).

Four primary elements in an option grant are number of shares, strike price, vesting and expiry date.

The strike price is always higher than the current company stock price at the time of grant.

For example, you, as the Vice President of Sales, are granted with stock options of 10,000 shares, with strike price of $ 50 (assuming current stock price of $ 30) with expiry date of 2 years from now. It may also come with a vesting schedule; for instance, only 50 percent of the options are exercisable in the first year.

Within the next 2 years, you lead the team to grow company sales by three fold. As a result, stock price surges to $ 65. Now you have the rights, but not the obligation to exercise your stock option to buy the 10,000 units of shares at the price of $ 50.

If, you failed to perform in your role, or for whatever reason beyond your control that renders your company stock price to stay below $ 50 mark, your stock option is in a state known as “underwater”. It is worthless at the last trading day by the end of the second year.

Purpose

Motivates employee into achieving short term goals. A listed company earnings and revenue growth are known to be positively correlated to its share price.

Grant is usually made to company senior leaders whose decision impacts company top and bottom line, which could directly influences investors confidence and perception towards to company. Practically, grant to other exempt level employees is not so relevant if their responsibilities or decision lack the capability to affect company stock price.

How to profit

Exercising your stock option and sell 10,000 units of shares in the market for $ 65. You profit by $ 150,000 (10,000 x $ 15).

Cons

It does little to instil sense of ownership, and it often viewed by most as high risk gamble which potentially yield great reward. Loyalty is up to the stage of raising the stock price so that stock option owner can cash out and make a bundle.

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Equity compensation reduces the amount of cash compensation. It acts as a deferred form of incentive for employee productivity. Equity compensation are subject to forfeiture under voluntary or involuntary termination of employment.

Trivia: Apple CEO, Tim Cook, was awarded 1,000,000 RSU in Jan 2012, with vesting schedule of 50 percent in the next 5 years and the remaining half in the next 10 years. Go figure on how much he is worth today  just by this RSU grant alone.

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