Many companies choose to compensate their employees with various forms of equity.
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This article seeks to explain some of the common methods of non-cash equity compensation.
This is the most basic form of compensation which simply grants shares of a company to an employee.
If you are able to freely keep or sell the stock, the shares granted to you are considered vested and you must report them as compensation income.
Sometimes stocks granted as compensation will have certain restrictions which require that you sell the stock back to the company in the case of a termination For example, the restriction may require that you sell it back at the price it was granted to you or it may allow you to sell it back at market value. Depending on the performance of the company, either agreement could be beneficial to the employee granted the stock.
Restricted stock is a form of stock compensation which includes a vesting period, that is, an amount of time that must pass before the stock is vested and considered yours to keep.
Restricted stock grants are often "restricted" in the sense that the vesting period is dependent on a certain date or a certain goal to be achieved. For example, a company could issue 100 shares of restricted stock with a vesting period of three months, which would give the employee 100 shares of stock after a period of three months at the market value at that time.
A company could also issue 100 shares of restricted stock with a vesting period that ends when the company reaches a certain sales goal or pays off a certain amount of debt. The stock will then vest whenever that goal is achieved, independent of any period of time. Restricted stock is cancelled if an employee is terminated before the stock is vested.
Incentive (or Qualified) Stock Options
Incentive stock options (commonly known as ISOs) are options granted to employees giving them the opportunity to purchase stock of a company at a specified strike price.
Incentive stock options are more restrictive than non-qualified options—for one, they are not allowed to be provided at a discount to the current stock price. Also, incentive stock options are non-transferable, except through a will.
So what are the benefit of ISOs? When granted incentive stock options, an employee does not have to record it as income, and, even after he exercises the option to purchase the stock, is only taxed when he decides to sell the stock. With such rules, an employee can avoid the more costly personal income tax and only pay long term capital gains tax if he waits two years from the date he was granted the option and a year or more to sell the stocks that were acquired through this option. Also, incentive stock options provide a tax benefit to the company issuing them.
Non-qualified options differ from ISOs (qualified options) in that they must be recorded as income when the option is exercised and tax is paid on the difference between the market value of the stock and the strike price of the option. Non-qualified options are not as restricted as incentive stock options and can sometimes be transferred to another party.
Hopefully you now have a better understanding of the different basic methods companies use for non-cash equity compensation.