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8 Common Terms within Equity Compensation and What They Mean
Equity compensation comes with its own lexicon that can often be overwhelming. Understanding these terms is crucial in making informed decisions and maximizing the potential benefits of your compensation package. This guide breaks down some essential terminology you will likely encounter when dealing with equity awards such as RSUs, ISOs, and NSOs.
Vesting is the process by which an employee gains ownership of stock awards or options over time. This schedule, set by the company, determines when you become the owner of these assets and can exercise control over them. It’s a method used by companies to retain talent, as you’ll have to remain employed for a certain period to fully “vest” and claim your complete award.
‘Cliff vesting’ is a term used to describe a situation in which employees become fully vested at a specific point in time, rather than becoming gradually vested over an extended period. With a cliff vest, you’ll earn the right to the full amount of stock or options (as outlined in your agreement) once you hit a specific anniversary date, usually one to four years from the grant date, rather than a percentage vesting on a pro-rata basis over several years.
For example, if you have a four-year cliff vest, none of your grant will vest until your fourth anniversary with the company, at which point all of your shares would be fully vested.
A ‘grant’ refers to the issuance of equity awards by the employer. It’s essentially the company’s promise to give you stock or options under specific conditions, typically formalized through the “grant agreement.” This agreement outlines vital details, including the number of shares, vesting schedule, and expiration date.
Strike Price (or Exercise Price)
The ‘strike price’ or ‘exercise price’ is the predetermined price at which an employee can buy the company’s stock when exercising stock options. For employees, the hope is that the company’s stock increases in value, making the option to purchase at the strike price more valuable.
To ‘exercise’ means to use your right to buy the company’s stock at the strike price. It’s a critical step for stock options (ISOs or NSOs) as it turns the option’s potential into an actual share of stock (or cash). This step typically requires deciding when to exercise and potentially sell, factors often influenced by tax implications, market conditions, and personal financial status.
The ‘bargain element’ is the difference between the exercise price (strike price) and the stock’s market value at the time of exercise. While this represents a financial gain on paper, different tax rules apply to this value depending on whether you have ISOs or NSOs, which can significantly impact your tax liability.
Alternative Minimum Tax (AMT)
The Alternative Minimum Tax is designed to ensure that individuals who benefit from certain tax advantages pay at least a minimum amount of tax. It operates alongside regular income tax and requires you to compute your taxable income under two systems: the standard tax system and the AMT’s system, eventually paying whichever amount is higher. It affects employees exercising ISOs because the bargain element can be subject to AMT. It’s vital to consider potential AMT implications in your tax planning.
A ‘lock-up period’ is a restriction following an initial public offering (IPO), preventing insiders (including employees who own stock) from selling their shares for a specified period. It’s designed to prevent the market from being flooded with too many of a company’s shares at once, which could devalue the stock.
Navigating the landscape of equity compensation can be complex, but understanding these key terms lays the groundwork for deeper insights into your stock awards. Given these concepts’ financial and tax implications, consider engaging with a financial advisor to make strategic decisions about your equity compensation in alignment with your overall financial planning.
This is for informational purposes only and does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product or services. The content is provided solely for your personal use and shall not be deemed to provide access to any particular transaction or investment opportunity. Amplius Wealth Advisors, LLC does not intend the information to be investment advice, and the information should not be relied upon to make an investment decision. Any third-party information contained herein was prepared by sources deemed to be reliable but is not guaranteed.