With the increasingly competitive landscape of the pharma/biotech marketplace, companies are becoming more creative with their equity plan offerings to recruit and retain top talent. Learning how to maximize the benefits offered to you can make a big difference in your ability to achieve your financial goals. Each of the different equity plans have nuances that, if misunderstood, could cause you to leave money on the table, overpay in taxes, or leave you with a concentrated position you’re unsure of how to divest. 

One of the more common themes we see in working with clients at rapidly growing companies that offer equity as a main component of total compensation is the PAC-MAN™-effect. What starts as a small percentage of total net worth in the early phases of employment quickly becomes the single, largest holding in a portfolio. When this goes unplanned, or worse unwatched, it can create problems that are seemingly more complex than they otherwise would be. 

Restricted Stock

Restricted stock plans are used by companies as a long-term incentive tool to retain and reward employees by granting shares of the company to its employees. The key components with restricted stock are grants, vesting schedules, and the tax treatment of the shares. 

Grants or awards are typically given annually and tied to performance or tenure at the company. They can also be issued for special projects, sign-on bonuses, or as retention tool to keep top talent. Each grant will have a value base or a share base that will be distributed according to a vesting schedule.

Vesting schedules vary based on the type of grant, but typically follow a 3 or 4 year distribution period where some amount of the shares gets distributed quarterly or annually over that time frame. If you’re nearing retirement some companies will also have a policy for accelerating vesting based on age and tenure at the company. Understanding your company’s policy and your own retirement timeline can help you plan for additional income in the year of retirement as a result, or potentially selling at a more favorable tax rate depending on other retirement income sources.

There are no immediate tax implications of being issued a grant of restricted stock. When shares vest the entire market value of the amount vested is typically included as income tax in the year they are received. Now that the shares have vested, it’s important to consider how they will be taxed when they are sold. If you sell the shares within 1 year of the date that they vested you will be taxed on that gain/loss at ordinary income tax rates. If the shares are held for over a year from the time they vest the gain/loss will follow long-term capital gains tax treatment.

Takeaways for Restricted Stock

  • Make sure you understand your vesting schedule for each grant and use that to predict total income/cash flow for future years
    • Acceleration of benefits for retirement?
  • Know that any shares that vest in a given year are added to your total taxable income for that year (unless you use an 83(b) election)
  • Understand the timeframe in which you sell your vested shares matters for how they are taxed
    • A common misconception is that you should always sell your “oldest” shares first. That isn’t always the case and working with a professional to identify specific lots when the time comes to sell can help you control your tax liability.
  • Know your company’s trading restrictions i.e. blackout dates, trading windows, etc.

ESPP

An Employee Stock Purchase Plan (ESPP) allows employees to purchase shares of the company, typically at a discount, at certain times throughout the year through an elective payroll deduction. You don’t have to participate in the plan, and usually are not automatically enrolled in the plan. There may also be certain restrictions based on the plan document. Below are some of the important components of most ESPP plans:

  • Enrollment period
  • Offering Dates & Purchase Dates
  • Discount Rate (and what that discount rate is based off of (anchor price))
  • How long do you need to hold it before you can sell?
  • What changes can you make while you’re enrolled in an offering?
    • Can you change contribution %? If so, how many times?
    • Can you withdraw from the offering?
  • Minimum & Maximum contribution rates (or $ figure)

Depending on your company plan specifics ESPPs are one of the few places to capitalize on “free money” offered up by the employer aside from a company match/profit sharing in a 401(k). If used correctly and plan specifics allow, employees can use their ESPP to take advantage of a “guaranteed” return. 

The tax treatment of ESPP can get somewhat muddy. Talking with a financial professional to understand the intricacies of the plan can help you avoid an unwanted tax surprise.

Takeaways for ESPP

  • The discount within the plan offers an opportunity for “guaranteed” ROR if used correctly
  • Know your plan details and what changes can be made
  • Having an effective sale strategy is equally as important as having a plan to buy

Options

Stock options are one of the most misunderstood equity compensation plans, but they don’t have to be! In essence, a stock option gives the employee the “option” to buy a certain number of shares of their company stock at a stated price (grant price). Options grant recipients then have to decide if/when to exercise that option within a specified period of time (typically 10 years from the grant date – note that expiration dates may vary based on each plan). The value of the option grows when the underlying stock price appreciates above and beyond the grant price.

The two most common types of options issued by companies are Non-Qualified Stock Options (NQSOs) and Incentive Stock Options (ISOs). While the elements in the options remain the same the biggest difference between NQSOs and ISOs is the tax implication upon exercise. This difference could dictate your entire strategy around your equity based compensation.

Let’s say that the company you work for has appreciated in value and you’d like to exercise your options. Now what? The option itself gives the employee the right to purchase the underlying stock…but what if you also wanted to sell that stock to realize the value between the grant price and the current market price (bargain element).

Cashless exercise is the most common way to exercise non-qualified options. Appropriately named, the grant recipient doesn’t need to come up with any cash to purchase the underlying shares. The shares are simultaneously purchased and sold by the custodian, with the remaining proceeds deposited as cash into the recipient’s account.

With ISOs, cashless exercise is still a method to exercise the options, but by doing so you may forgo the more favorable long-term capital gains treatment upon the sale of the underlying stock. The bargain element in this case would be taxed as ordinary income. This brings us to another way to exercise options; cash exchange.

Utilizing a cash exchange for ISOs – the option holder would exercise the option to purchase the underlying shares at the grant price. If the shares are then held for one year after purchase the gain from a subsequent sale of those shares would be taxed at long term capital gains rates. While this provides a potentially more tax favorable situation, it requires capital outlay from the grant recipient to purchase the shares. There is also risk that the market price may fluctuate or even be less valuable than it was at the time of exercise. 

Takeaways for Options

  • Understand the type of options you’re granted and their tax implications (NQSO vs. ISO)
  • Evaluate your exercise options and balance that with your cash flow and risk profile
  • Monitor the expiration dates

Connecting the Dots

Understanding the basics of all the different equity plans offered through your employer is the first step of getting the most out of them. You can really start to maximize the value when you connect the dots between them to work in your favor towards your financial objectives. As you spend more time at one company and see your equity based compensation grow to the size where it represents a large portion of your portfolio consider implementing a process for diversification. Utilizing a 10b5-1 trading plan can help alleviate emotional decision making, trade throughout blackout windows, and help keep your single stock exposure at a comfortable level. 

If you know your company stock makes up more of your portfolio than you’re comfortable with, want to understand the components of your equity plans better, or need help with a sale strategy reach out to our team for guidance. 

*Disclaimer

The assumption of “free-money” or a “guaranteed” return assumes that you sell shares immediately after purchase to capitalize on the discount offered through the plan document. 

Purshe Kaplan Sterling Investments and McAdam LLC dba LRVS Advisory Group are not affiliated companies. This article is provided by McAdam LLC dba LRVS (for informational purposes only. Investing involves the risk of loss and investors should be prepared to bear potential losses. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. No portion of this article is to be construed as a solicitation to buy or sell a security or the provision of personalized investment, tax or legal advice. Certain information contained in this report is derived from sources that McAdam believes to be reliable; however, the Firm does not guarantee the accuracy or timeliness of such information and assumes no liability for any resulting damages.