Stock-Based Awards: What’s New and What’s Not
When you are presented with several forms of stock-based compensation, how do you assess what they are and how they work? What are some of the key features of stock options, restricted stock/RSUs, and ESPPs to maximize your potential wealth accumulation?
Executive compensation has come of age. Stock options have been a major part of U.S. executive pay since the 1950s, rising in popularity then due to a favorable tax treatment. Some 70 years later, stock options no longer represent the dominant form of long-term equity incentives. Instead, there are new and targeted stock-based awards companies use to meet a range of needs and rewards. As they have grown in number and complexity, executives may find it harder than ever to assess these significant sources of wealth and prioritize them as sources of funds.
To illustrate a variety of awards and how they work, we introduce you to three executives at three levels of the company. Each is experiencing an award type for the first time and is learning the ins and outs of various stock-based awards.
Building Wealth through a Broad-Based Stock Plan
Clarissa, Marketing Manager*
Clarissa had initiate participation in the Employee Stock Purchase Plan (ESPP). She authorizes a small systematic payroll deduction of a small amount to participate in buying company shares. The company collects and accumulates her payroll deductions for up to six months. Then the shares are assigned a purchase price equal to the lowest market price over the last six months. In addition, the company provides a 15% discount in additional shares, so that employees can build shares. As long as Clarissa holds the shares long term, she can claim capital gains on the sale, avoiding a disqualifying disposition that would trigger a higher tax rate.
Recently, Clarissa has been awarded a first grant of Nonqualified Stock Options (NQOs). These awards permit her to buy company shares at a fixed price – usually the market price on the date they are granted - and sell them in the future at the prevailing market price.
Nonqualified Options (NQOs) and Stock Appreciation Plans (SARs)
Scott, Vice President*
From early in his career, Scott was awarded stock options. While he was presented with a mix of Incentive Stock Options (ISOs) and Nonqualified Options (NQOs), he has noticed the company favors NQOs now, because they can expense the awards as a compensation. Scott had been familiar with Restricted Stock Units as well as Stock Appreciation Rights (SARs) from his recent assignment with a non-US company.
SARs are even more attractive to the executive than NQOs. Like options, SARs are bonused to the executive as a reward when the company performs well. The only cost to the executive for SARs is the taxes they pay; while NQOs require the executive to pay the strike price on the option grants. Why aren’t SARs more popular, he wonders?
Welcome to the C-Suite
Ellen B., Senior Vice President*
Company veteran Ellen has earned a promotion to senior vice president. Now in her 50s and a brilliant strategist, she has been familiar with Restricted Stock Awards and Stock Options over her long career.
Ellen faces a performance-based compensation culture in the C-suite, where the rewards are significant, and the stakes are high. Ellen’s compensation is now tied to the success of her team’s strategy. Ellen has been granted performance awards in the form of Performance Stock Units (PSUs). These awards commit a targeted number of company shares to a cash equivalent at a future date, once vested. Vesting of these awards is the point at which they are fully owned, and you have the right to sell, transfer or assign these shares.
The trends in stock-based compensation in 2021 favor performance-based awards. Shareholders are pressing for more accountability in awarding stock-based compensation. Proxy advisors have been driving a rising trend for companies to issue Performance Stock Units (PSUs) and Restricted Stock Units (RSUs) to align rewards with company performance. Ellen’s PSUs will vest based on meeting company performance targets.
Performance-based awards specify strategic or financial targets to be met to trigger vesting. The most common performance metrics that may trigger vesting include absolute or relative total shareholder return, revenue, EPS, ROI. You may also see stock bonuses tied to financial or nonfinancial metrics such as operational performance targets, the launch of a new product, customer satisfaction or other benchmarks. These pay-for-performance forms maintain skin in the game for executives, thus benefitting the company and the shareholders.
Finally, there is a science to long-term incentives in terms of taxes, timing and diversification. SFG can help you with divestiture planning. The executive is responsible for determining the cost basis, while SFG can be an astute partner and advisor for planning and tax-savvy divesture.
*The name, likeness, and circumstances in this example are a fictional composite of facts from executives similar to actual SFG Clients.