top of page
  • Writer's pictureMarcus P. Miller, CFP®, MBA

Are you a tech employee? Here's what you need to know about stock-based compensation

Stock-based compensation is a form of compensation given to employees in the form of company stock or stock options. Companies use this as a way to reward and attract talented employees.


How does stock-based compensation work?

Employees are typically given either company stock or options to purchase the company’s stock at a predetermined price. If the employee chooses to accept stock as compensation, they will own shares in the company and benefit from any appreciation in the stock price. If they choose to accept options, they will have the right (but not the obligation) to purchase a specified number of shares of the company’s stock at a predetermined price. If the stock price rises above the option's strike price, then the employee can benefit from the difference.


How stocks are valued and their performance monitored

The company stock or options are typically valued based on the company’s current stock price. For non-publicly traded companies, this is done through a process called a 409A valuation. In this process, an independent third party assesses the company’s value and determines the fair market value of the company’s stock. The 409A valuation is used to ensure that all employee stock compensation is granted at a fair price. A liquidity event may also be used to provide a market-based valuation of the company’s stock; this is when the company is acquired, merges with another company, goes public, or has some other type of transaction that allows founders and early investors in the company to cash out their ownership shares.


409A Valuation

A 409a valuation is an appraisal of a company’s common stock that takes into account current market trends and conditions. It is used to determine the fair market value of the stock, which is important for privately-held companies that need to provide evidence that their stock price is accurate. The 409a valuation also helps ensure there are no tax implications related to overstating the value of a company's stocks, protecting employees from unfair taxation.


Why are 409a valuations important?

Companies use 409a valuations to comply with Internal Revenue Services (IRS) regulations and demonstrate compliance in regards to setting the right price for their common stocks. Without these valuations, companies could potentially take advantage of loopholes and commit fraud. 409a valuations help ensure that companies are not overstating their stock prices and that employees are paying the correct amount of taxes on stock options they receive.


What does a 409a valuation include?

A 409a valuation is an appraisal process that takes into account current market trends and conditions related to a company’s common stocks. This includes an analysis of financial performance such as revenue growth, key performance indicators (KPIs) and other factors that may affect the value of the company’s stocks. The process also involves looking at past FMV appraisals and other comparable companies to determine the fair market value of the company’s stocks.


Who performs 409a valuations?

409a valuations are typically performed by experienced professionals who have an understanding of financial reporting, accounting standards, corporate tax regulations and other factors that can impact stock prices. This could include financial advisors, accounting firms or private equity/venture capital firms that specialize in this type of valuation. It is important to work with someone who has experience with these types of appraisals to ensure accurate results.


What is the purpose of a 409a valuation?

The primary purpose of a 409a valuation is to help companies comply with IRS regulations when setting the right price for their common stock. It is also used to ensure that stock options are not overstated and that employees are paying the correct amount of taxes on these options. Additionally, it helps protect companies from potential fraud by making sure they do not overstate the value of their stocks. This ensures fair market value appraisals are accurate and helps create a level playing field in regard to the taxation of employee stock options.


How often should a 409a valuation be done?

It is recommended that companies perform 409a valuations at least once a year and when major changes occur within the company such as stock splits or corporate restructuring. This helps ensure the appraised value of their common stocks is accurate and up-to-date, which helps protect the company from any potential tax liabilities related to overstating the value of their common stocks. An annual review also allows companies to identify any discrepancies or areas that need improvement, providing greater accuracy in regard to fair market value appraisals.


What are the consequences of not performing a 409a valuation?

Not performing a 409a valuation can result in considerable financial penalties, reputational damage, and even potential legal action. Companies that do not comply with IRS regulations may be subject to significant fines as well as other liabilities for any taxes that have been understated or overstated. Additionally, companies may also face charges of fraud if they are found to have taken advantage of loopholes in the system by overstating the value of their common stocks. Therefore, it is important to perform a 409a valuation on a regular basis in order to remain compliant and protect the company from potential risks.

Types of stock options available to employees

The four major types of stock-based compensation available to employees are Restricted Stock Units (RSUs), Restricted Stock Awards (RSAs), Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs).


Restricted Stock Units (RSUs)

Restricted Stock Units (RSUs) are a form of equity-based compensation that can help companies attract and retain key employees. RSUs are grants of company stock that vest over a period of time, with the terms of vesting established in advance. Employees receive the stock once it vests, and typically have no upfront cost to the employee. The number of RSUs granted is usually based on a percentage of base salary and when an employee is granted RSUs, the stock price is generally based on the market value of the company’s stock at that time. However, if the company's stock does not appreciate in value or suffers losses, then employees who have been awarded RSUs will typically not benefit from them financially. Depending on their vesting schedule, RSUs may be subject to taxes when they vest or when the employee sells them. Companies typically use liquidity restrictions that require a tender offer or other exit in order for the employee to liquidate their shares. All in all, RSUs are an increasingly popular form of equity-based compensation for employees and can help companies attract and retain key employees.


Restricted Stock Awards (RSAs)

Restricted Stock Awards (RSAs) are a form of equity-based compensation that offer employees the potential to gain or lose financial gain depending on their company’s stock price. Unlike RSUs, which are granted by the company, an employee purchases RSAs with a predetermined amount and is subject to restrictions on when and how many shares can be sold based on their vesting schedule and terms of the award. This provides employees with greater control over their financial future since they can sell immediately after vesting or wait until the stock price rises to a predetermined level. All in all, RSAs are an increasingly popular form of equity-based compensation for employees that offers potential financial gain and greater control over their financial future.


Incentive Stock Options (ISOs)

Incentive Stock Options (ISOs) are grants of options to buy the company’s stock at a discounted rate. With ISOs, employees must hold the stock for at least one year after exercising their options and two years since the grant date in order to benefit from long-term capital gains treatment. This can offer tax advantages to the employee, depending on certain conditions being met. There are several details to consider when granting ISOs, including vesting schedules and tax implications that should be understood prior to exercising them. A typical vesting schedule for ISOs is based on a four-year period with a one-year cliff, meaning that employees must wait at least one year before they can begin to exercise their options and gain any benefit from them. If an employee leaves the company prior to the end of the vesting schedule, they may forfeit any unvested ISOs or be subject to other restrictions in the option agreement. Overall, ISOs offer potential benefits for employees that should be considered carefully before exercising them.


Non-Qualified Stock Options (NSOs)

Non-Qualified Stock Options (NSOs) are granted at a predetermined exercise price, without special tax treatment associated with them. They typically involve fewer restrictions than ISOs in terms of when the employee can sell the stock and what happens if the company's stock price decreases. Employees who receive NSOs will owe regular income tax on any gains realized from exercising their options and may be subject to alternative minimum taxation (AMT) when exercising them. The terms of each NSO grant are typically specified in an option agreement that outlines expectations, vesting schedules, and other details related to the grant. Vesting for NSOs is typically based on time- or performance-based criteria. Employees must pay ordinary income tax on the spread between the strike price and the fair market value (FMV) of the stock when they exercise their options, due immediately without waiting until April to pay it. When employees sell their stock, they will report any capital gains or losses.


The pros and cons of stock-based compensation

The primary benefit of stock-based compensation is the potential to increase an employee’s wealth. Employees can benefit from increases in the company’s stock price and, if their options are exercised, will have ownership of shares in the company. Additionally, employees who are granted RSUs or RSAs may receive a dividend payment on their shares, depending on the company’s dividend policy.


The biggest drawback of stock-based compensation is that it can be risky and volatile. The value of the employee's shares or options will depend on how well the company performs in the future, and there are no guarantees that the stock price will increase. Additionally, if the company goes bankrupt or is acquired by another company, the employee may not receive any value for their stock or options. Finally, depending on the type of option granted, there could be significant tax implications for the employee upon exercising their options.


How to maximize your stock-based compensation

When evaluating stock-based compensation, it is important for employees to consider the potential risks and returns associated with their options. Employees should research the company’s performance over time and any future plans that could affect the stock price. Additionally, they should consider how long they will hold onto their shares or options before selling them.


Taking advantage of tax benefits associated with stocks

For employees who are granted ISOs, it is important to understand the tax implications associated with exercising the options. Depending on their individual situation, an employee may be able to take advantage of the lower tax rates associated with long-term capital gains. Additionally, an employee may be able to use a strategy called “net exercise” in order to minimize the tax implications of exercising their ISOs.


Diversifying your investments

Employees should consider diversifying their stock-based compensation by investing in a variety of different stocks, mutual funds, and other financial instruments. This can help to reduce the risk associated with a single stock’s performance as well as provide a more balanced return on investment.



Taxation of stock-based compensation


Restricted Stock Units (RSUs)

Restricted Stock Units (RSUs) are typically given in lieu of cash bonuses and other forms of compensation. When the units are vested, any resulting gains are taxed as ordinary income. There may be what's called a “double-trigger” which requires both the RSUs to be vested and a liquidity event, such as an IPO, merger/acquisition or private sale of the company before they can be taxed. If both events occur, then any gains are treated as ordinary income and taxed at higher rates than capital gains.


Restricted Stock Awards (RSAs)

Restricted Stock Awards (RSAs) owe regular income tax on any gains realized from vesting their options. When RSAs are purchased, there are no taxes due. However, when they vest, ordinary income tax is payable on the gain between the purchase price and the FMV at vesting. Upon sale of the shares, capital gains tax is then due on any further gains between the FMV at vesting and the sale price.


Incentive Stock Options (ISOs)

Incentive Stock Options (ISOs) offer preferential tax treatment for recipients. When ISOs are exercised, any gains are subject to AMT tax but not regular income tax. Additionally, if an employee holds the shares for more than one year after exercising their options before selling, they may be eligible for long-term capital gains rates which can potentially result in a lower overall tax burden. However, employees must wait at least one year from exercise and two years from grant date before they can begin to exercise their options and utilize this benefit. If the shares are sold prior to the holding period then any gains are treated as short-term capital gains and taxed at income rates.


Non-Qualified Stock Options (NSOs)

Non-Qualified Stock Options (NSOs) do not offer preferential tax treatment like ISOs and instead are subject to regular income tax when exercised. Employees must pay ordinary income tax on the spread between the strike price and the fair market value (FMV) of the stock when they exercise their options, due immediately without waiting until April to pay it. When employees sell their stock, they will report any capital gains or losses.


Alternative Minimum Tax (AMT)

The Alternative Minimum Tax (AMT) is a separate tax system from the regular income tax and must be taken into consideration when exercising stock options. It applies to any gains arising from ISOs, NSOs, RSAs or RSUs that exceed the annual exemption amount. As the complexities of AMT are beyond the scope of this article, employees should consult with their financial advisor to determine if they are subject to the AMT and if any additional taxes will be owed upon exercising. A key factor to keep in mind when dealing with the alternative minimum tax (AMT) is that it must be paid right away upon exercise. This is why most people typically avoid AMT if at all possible.


83(B) Election

If you are given stock options from your company, you may owe taxes on the gain when you exercise them. If your company allows you to exercise unvested shares, you can make an 83(b) election within 30 days of early exercise. This means that rather than paying taxes on the gain right away, you will only have to pay the strike price to your company. You won't owe any taxes or AMT. If you keep your shares for two years from the date of the grant and at least one year past exercise, then any amount above strike price will be subject to long-term capital gains taxes upon sale. This can help save you money in taxes and is a good way of avoiding paying taxes immediately.


Vesting schedules for stock options

Vesting schedules are typically used to determine when employees can exercise their options. Vesting schedules are set by the company and vary depending on the option type and the employee’s role within the company. Generally, vesting schedules for ISOs and NSOs range from one to four years, while vesting schedules for RSUs or RSAs can range from one to five years.


Understanding cliff vesting

Cliff vesting is a type of vesting schedule that allows employees to exercise their options after a certain amount of time has elapsed. For example, if an employee is granted ISOs with a four-year cliff vesting schedule, they will be granted the first 25% at their 1-year mark, and the last 75% prorated through the last 36 months.



Things to consider


What happens if the company's stock price goes down?

Employees should be aware of the potential risks associated with stock-based compensation. If the company’s stock price goes down after the options are granted, the value of the options may be significantly less than when they were granted. Additionally, if the employee leaves their job before the options vest, they may not be able to exercise their options.


How to diversify your portfolio to protect yourself from a single stock's performance

In order to protect themselves from the potential risks associated with stock-based compensation, employees should diversify their portfolios by investing in various stocks, mutual funds, and other financial instruments. This will help to reduce the risk associated with a single stock’s performance as well as provide a more balanced return on investment.


Should you take advantage of stock-based compensation or invest the money elsewhere?

The decision of whether to take advantage of stock-based compensation or invest the money elsewhere is a personal one. Employees should consider their current financial situation, future financial goals, and risk tolerance when making this decision. They should also consider their company’s stock performance over time and any vesting schedules or restrictions.


When should I exercise?

If you are an employee of a public company with unexercised options, you may want to exercise your options immediately if you can cover any potential AMT that may be due the following tax season. If not, you can wait until January to exercise and sell the shares in the following January so that you have the proceeds to cover your tax bill due in April.


For those at companies about to go public, consider exercising around the time your company files with the SEC or waiting until January when future proceeds can cover any AMT payments.


For companies with private equity markets such as EquityZen or SharePost, consider offloading some shares by exercising in January or simply wait for an IPO.


Finally, those at brand new companies should consider early exercising using an 83(b) election if it only costs a few thousand dollars, as this could be very beneficial in the long run.


Talk to a financial advisor if you're not sure

If an employee is not sure how to proceed with their stock-based compensation, they should talk to a Certified Financial Planner with experience in deferred compensation strategies. A Certified Financial Planner can help the employee consider their current situation and assess their risk tolerance as well as develop a plan for investing that meets their individual goals.

Legal Disclosure

The opinions expressed in this website are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security. We cannot provide financial advice if we do not know your specific financial situation. Please talk to your financial advisor or do your own research before making financial decisions. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Any indices referenced for comparison are unmanaged and cannot be invested into directly. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

bottom of page