Equity compensation is a common feature in executive compensation packages. This is almost standard issue in the pharmaceutical world, where many of our clients operate.
On one hand, few compensation forms offer as much wealth-building power as equity. That said, you usually get them because you’re an expert at something else, not the ins and outs of equity compensation.
Maximizing the value of your equity compensation helps you have a working knowledge of the basic terms you’ll encounter along the way.
- Types of equity compensation
- Mitigating over-concentration risk
- Tax planning
- Avoiding insider penalties
- How it impacts estate planning
If you are considering a transition or promotion, we have built a compensation calculator that helps you measure the all-in value of your compensation offers over time. If you would like to see your options visualized, click here and say hello!
Understand Your Equity Award Types
The first step in managing equity compensation is knowing what you’ve been granted. While some of these terms may sound the same, there are critical differences. (Options are not stocks…)
Each type has unique characteristics and tax implications:
Stock Options: These allow you to purchase company stock at a set price, known as the exercise price. If your company’s stock price rises above the exercise price, you can buy the stock at a discount. You do not own any of these stocks without exercising your option.
Incentive Stock Options (ISOs): These have favorable tax treatment but come with conditions, such as holding periods to qualify for lower taxes.
Non-Qualified Stock Options (NSOs): These are more common but are taxed as regular income when exercised.
Restricted Stock Units (RSUs): These are company shares that vest (become yours) after meeting specific conditions, such as time served or performance targets. Upon vesting, they’re taxed as income.
Performance Shares: These are stock grants tied to achieving certain business milestones or personal performance goals.
Actionable Tip: Review your equity plan documents with a financial advisor to understand the rules and deadlines. Pay special attention to vesting schedules, which dictate when the shares become yours.
2. Mitigate Concentration Risk
As an executive, you may accumulate a large portion of your wealth in company stock. While this can be lucrative during strong performance, it creates risk if the company falters. A downturn can affect both your income and the value of your investments.
What You Can Do
Diversify: Reallocate a portion of vested shares to other asset classes, like mutual funds, bonds, or index funds, to reduce dependency on your company’s success.
Exchange Funds: These allow you to pool your company shares with others and exchange them for a diversified portfolio. This helps reduce risk without immediately triggering taxes.
Example: If 50% of your net worth is in your company’s stock, consider selling some vested shares to spread your investments across other sectors, protecting your financial future. That said, do so in a manner that doesn’t trigger adverse tax consequences.
3. Plan for Taxes Strategically
Taxes on equity compensation can be significant and depend on the type of award and how you handle it. Without proper planning, taxes can take a large bite out of your earnings.
Ordinary Income Tax: Stock options or RSUs are often taxed as regular income when you exercise (buy the stock) or vest (when shares become yours).
Capital Gains Tax: If you hold your shares after exercising or vesting, any increase in value may qualify for lower tax rates when you sell. Long-term capital gains apply if you’ve held the stock for more than a year.
Strategies to Reduce Taxes
- Time the exercise of options or sale of RSUs for years when your overall income is lower.
- For RSUs, plan sales around vesting dates to cover tax withholding requirements and avoid surprises.
- Consider an 83(b) election for certain awards. This lets you pay taxes upfront, potentially at a lower rate, rather than later when the value has increased.
In all honesty, this is a conversation that should almost never be DIY’d. There are layers and complex rules that escalate this exercise more than most expect.
4. Use 10b5-1 Plans to Manage Insider Restrictions
As an executive, you may face restrictions on when you can sell company stock to avoid accusations of insider trading. This can complicate your ability to sell shares at the right time.
A 10b5-1 Plan allows you to pre-schedule stock sales while complying with insider trading laws. You set up the plan during an “open window” period, specifying the dates or prices at which shares will be sold.
Example: You could set up a 10b5-1 plan to sell 10% of your RSUs every quarter, ensuring consistent diversification and compliance with regulations.
5. Incorporate Equity Into Estate Planning
Any time you have a wealth-accelerating part of your balance sheet; it has implications for your family. This is true both in terms of complexity as well as how a growing net worth impacts expectations.
What to Address
- Update Beneficiaries: Ensure equity awards pass smoothly to heirs by naming beneficiaries where applicable.
- Trust Planning: Placing shares in a trust can minimize estate taxes and provide guidance on how the assets should be managed or distributed.
- Coordinate with Advisors: Your financial advisor and estate attorney should work together to ensure alignment between your equity compensation and your broader estate plan.
Example: If you have a family trust, you could allocate vested RSUs to the trust to protect them from estate taxes and ensure they’re used according to your wishes.
Now, How To Think About Your Equity Comp
You have a significant opportunity to accelerate your wealth when equity is in play, but it can also be a source of stress and unnecessary risk. This level of planning is best done by a team that has been doing it for a long time.
At Vizionary, we have spent over 20 years uniquely focused on the pharma and life science industries. From complex compensation to volatile industry dynamics, we are here to help you Envizion More for you and your family.