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Stock Vesting: Waiting for the Keys to Your Golden Handcuffs

Episode 7

Stock Vesting: Waiting for the Keys to Your Golden Handcuffs

Posted August 8, 2023
Cassidy Clement , Barbara Olander
Interactive Brokers

You got equity compensation, that’s great! Wait..what is that?  What is stock vesting? How does it work? Interactive Brokers’ Senior Manager of SEO and Content Cassidy Clement and Total Rewards Manager Barbara Olander discuss stock vesting programs and other details associated to them.

Summary – Cents of Security Ep. 7

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement

Welcome back. I’m Cassidy Clement, senior manager of SEO and content at Interactive Brokers. Today, I’m your host for our stock vesting podcast and our guest, Barbara Olander, the total rewards manager at IBKR is here to help us cover stock vesting programs and other details associated with them. Welcome to the program, everyone. Welcome back, Barbara. 

Barbara Olander

Hi all!

Cassidy Clement

So, I know that we’re going to say a lot of different things about vesting today as the word and as a verb. But I guess at the basics, I’m aware of stock vesting, about earning an asset over time, but the best intro question for most people is going to be, what is stock vesting? So, I know about the earning an asset over time, but for you, how would you explain it in HR speak? 

Barbara Olander

You are correct in that vesting means earning an asset overtime. Now that asset is going to be employer provided incentive that could be a 401K match. It could be the ability to purchase shares of the stock of the company through the available plans, but a vesting schedule, as frequently those two terms are coupled, just explains, or explicitly identifies the period of time over which an employee earns a particular asset or ability to use a benefit. So, very quickly, we talked about previously in another of our podcasts about 401K vesting. The vesting there applies to the employer match portion, meaning the employer money that is added to your retirement account, and the length of time over which it takes for the employee to receive it. 

Cassidy Clement

So, I know that there are several different plans that may apply, when people talk in general about stock vesting, but a popular one I guess is the ESOP, the employee stock ownership plan. And well that’s the employee benefit that encourages the employees to give their all and work to succeed, because then the company’s success can kind of translate into a little bit more of their own financial rewards or salary at the end of the year. While there are many different rules with those, I guess I’m not super familiar with it other than in a general conversational type understanding. So, how would you explain that from the big picture as a plan or a program. 

Barbara Olander

So, employers are trying to come up with different incentives for their employees in order to retain the top talent. An employee stock ownership plan allows the employee to purchase a stock offered by the employer at a particular point in the future on a pre-set price. So, it is one sort of way that employers try to incentivize employees to stay with them over a longer period of time. Other versions of employee ownership include direct purchase programs, different setups for stock options, restricted stock, and so on. We’re going to touch on a couple of these today.

Cassidy Clement

There seems to be a bunch of different options here, and I know that from what we’ve kind of talked about a little bit so far and what I’m familiar with, we have RSU’s ISO’s NGO’s with RSU’s for restricted stock units. At least my understanding, you don’t really need to purchase them on your own. You just need to wait for them to vest and those should be coming If you just started at a company, or maybe hit a milestone like an IPO or something like that.  They give out shares to some employees, and those will vest over time.  

The ISO’s and NSO’s which I believe are the incentive stock options and the non-qualified stock options, as far as I know, it’s the understanding that you have the right to buy these and It’s not necessarily like the RSU where they’re just given to you. So, can you tell me more a little bit more about what these are in comparison to an RSU and maybe if there is a key difference if you’re using these in the stock ownership plans, the ESOP’s versus a traditional RSU plan? 

Barbara Olander

So, an ISO or an incentive stock option is usually offered by the employer to key employees only.  The employer may decide to offer it to all employees. However, most commonly it is intended for those key employees. RSU is a plan that again can have very specific restrictions and who it applies to, but as you said, yes it allows the employer to grant.  So, to give employees some number of shares or units of stocks.  So, let’s go back to the employee stock ownership plans. As we said before, those types of plans only allow the ability to purchase shares at a set price at some point in the future.

The other side of that, or a different approach, to a long-term incentive would be the restricted stock options which you mentioned a minute ago and those are like I said, granted to the employee. The employee does not have to purchase RSU’s, they are given to them and frequently include a vesting schedule which requires the employee to stay with the company for a set period of time that could be three years, five years, some preset duration, in order to become vested in or have full ownership of the shares that they were granted.

So key differences between these two types of long-term incentive plans are that ESOP’s involve the option to purchase company shares at a predetermined price.  Whereas RSU are the restricted stock that employees receive as compensation and then they can sell them after they have vested in those shares. So that would be the key differences to point out to our listeners.

Cassidy Clement

So, for any of these stock units or stock options, is there anything with like dividend benefits or like voting rights that may differ between the plans or maybe is it something that happens based on what you’re given?

Barbara Olander

For ESOP’s, they frequently offer voting rights and dividend benefits, while RSU’s do not in some instances. And RSU can include a dividend equivalent payment, so it’s not a true dividend. It’s a payment that sort of resembles dividends and is an additional benefit to the employee, but it’s not a true dividend. 

Cassidy Clement

So, with these different plans, then— how do the securities vest? I know that there’s different types of schedules with different years or like fractions that you can use to see how many you’re looking at per year. But from my research, I saw there were different things called like yearly Cliffs— If you can explain that a little bit because I wasn’t super familiar with that.

Barbara Olander

Again, just to sort of bring it back to other plans that may include a vesting schedule, there are several types of schedules that are pretty common. For example, earning the benefit or the employer sponsored grant over a five-year period, for example, could mean that a person receives 20% for each year of employment that they are with the organization. After a 5-year period, they are entitled to 100% of a particular grant, so that would be sort of a longer-term vesting schedule, requiring the employee to stay with the company for a period of at least five years in order to take full advantage of the long-term incentive that is being offered.

Shorter vesting schedules also exist; some of them are called Cliff vesting schedules, which means that an employee receives zero or there’s not a fractional component of the benefit until the employee satisfies that full term requirement. So, for example, a one-year Cliff vesting would mean that if an employee leaves their employment within, let’s say, six or eight months, they would receive none of the benefit, whereas if they stay with the employer for at least a year, then 100% of that benefit becomes theirs. Now, and sort of a middle ground, there would be a three-year Cliff vesting schedule. So again, leaving the employment, you know, within the first three years means that the employee receives zero or none of the benefit, whereas if they stay at least three years with the employer, then they are entitled to 100% of that long term incentive, whether that be RSU’s or other retirement plan benefits, for example.

Cassidy Clement

You know the next natural thing for people who are familiar with different financial securities is ‘OK, great, I have these—What’s the catch? How are they taxed?’ So, you have the option to pay via cash or you’d wire it into that brokerage account to cover the taxation on the vesting. Or you can deduct from shares so the equivalent of the taxed amount valued at the amount of shares that would equal that. Are there any other ways that explain how their taxed?

Barbara Olander

Taxes, we all have to pay them. There is no way of escaping them and with a long-term incentive plan such as a stock options plan or the RSU’s that we discussed—There are two main ways of covering that tax requirement; either, you know, employees use their own funds to cover the tax expense or like you said, there is sort of that calculation to figure out how many of the granted shares would need to be used to satisfy the tax requirement, right? So, restricted stocks usually become taxable upon the completion of that vesting schedule, right? So, depending on how long that takes, that’s where the tax event also applies. For restricted stock plans, the entire amount of the vested stock must be counted as ordinary income for the year of vesting. The amount that must be declared is determined by a calculation of subtracting the original purchase price from the exercise price and then comparing that to the fair market value of this stock. However, if the shareholder does not sell the stock at vesting and sells that at the later time, then the difference between the sale price and the fair market value on the date of the vesting is reported as either gains or losses.

Cassidy Clement

Right.

Barbara Olander

So, for our listeners who as part of their overall compensation have a stock option plan and they are concerned about or have a particularly intricate taxable situation or tax situation just in their lives. Obviously, there is no better advice than that of a tax professional, you know, depending again on the sort of individual complexities that may exist; that’s the safest way to approach.

Cassidy Clement

Right. So, I know we covered a little bit— at the end there you’d mentioned about like the ‘OK, you have them now,’ and let’s say you paid taxes once they’ve vested, but now you want to sell them. So, I guess, a lot of people have questions about— ‘great, I have this awesome thing; now I’d like to see the cash.’ Many people will immediately think, ‘when can I sell all of them,’ which obviously you got to wait for your vesting schedule. But once they are vested, and they’re yours, as far as I know, they’re treated like any other stock, So, is there anything else involved with them? Maybe like the blackout period or anything else? I know, like ESOP’s, I’m not as familiar with, but with RSU’s, like the blackout dates or maybe different restrictions with when you can sell them as the employee.

Barbara Olander

Restricted stock units cannot be sold or transferred until they become yours, so again that vesting word…

Cassidy Clement

Yeah, right.

Barbara Olander

…plays a part. But once the shares are vested, they are yours and you are able to sell them. They may be based on the specific plan rules that apply to an individual’s employer plan that still have to be observed. So, for example, blackout dates, meaning a period of time where the plan restricts an employee’s ability to sell their vested shares to a specific period of time, could be a consideration that the employee needs to make all of those details— the restrictions of when and how and under what circumstances shares can be sold will be described in the in the planned documents. If long term incentives are part of your compensation package, reviewing those details, familiarizing yourself with those specific rules is very important so that you can sort of plan or better gauge when and how to use your earned shares.

Cassidy Clement

The next question, again, you have this awesome thing— What’s the catch? How are they taxed now? Because if you have things vesting at different times, are they treated technically like long term or short term because we mentioned a little bit about the capital gains and taxation rules here. But, you know, they’re sold after vesting, but not everybody has the exact same vesting schedule. So, how exactly does a person go about weighing what the taxation impact is going to be for their situation.

Barbara Olander

Excluding any sort of personal, special circumstances and tax events that need to be observed by the individual. If the shares are held for more than one year from the vesting date, any capital gains or losses will be considered long term. If the shares are held for one year or less, so months. Any capital gains or losses will be considered a short term. So, you know again, the taxable events determine on the duration of the employee maintaining that particular stock or being an active participant in that stock.

Cassidy Clement

That long term or short-term designation is from the actual vesting date. So, it’s from when they become not restricted and yours and that forward becomes your time for your figuring out your tax implication, I guess. Now the part that a lot of people visit, sometimes they don’t want to visit this. Sometimes it’s called the golden handcuffs, which is— you don’t want to have to leave behind anything that you didn’t get yet: What happens if you leave a company before they vest? Because some people open up that brokerage account and they’re like, ‘ohh geez, it may have been a rough day, but I can’t leave now.’ Look at that beautiful number in there. That’s a scary thing. So, what happens if you were to leave the company?

Barbara Olander

Yeah, so very much a valid question. And again, sort of ties back to the beginning of this conversation and that the whole point behind setting up these long-term incentive plans is for the employee to be sort of enticed into staying with a particular employer, right? That growing account balance as you continue to vest and sort of receive more grants for your contribution to the employer? You know, it makes the conversation about leaving that much more difficult. Well, most employers only require time-based vesting, so you’ll need to stay at the company long enough to earn those shares, right? Typically, a portion of the grant will begin after one year of service. As I said, that’s sort of the common, you know, at least fractional vesting schedule but the details of that again will be explained in the planned document. If your shares are vested, that’s definitely a good thing, obviously, because that means you have met the necessary requirements, leaving unvested shares behind due to your departure or termination from the employer, you know, again poses another question or considerations.

Cassidy Clement

When you’re leaving your company, a lot of it, you can probably find within the terms of your grant, as it’s company specific usually based on what you’re telling me and some of my research. But with these programs, are there any real caveats with the different types? I know we covered a lot today. I know for myself, the RSU is probably one of the most familiar items since it’s like, ‘hey, you’ll get this at this date and then it’s yours.’ Are there any specific comparisons or caveats that come with that?

Barbara Olander

I mean, maybe, let’s just quickly discuss the sort of pros and cons of restricted stock units. So, one of the pros would be that it incentivizes employees to stay with the company. Secondly, employees receive the capital gains, you know less the value of their shares withheld from income taxes. And, you know, there are minimal administrative costs, right?  So, the employee frequently has little to no cost and then on the employer side, right, from a planned perspective— those tend to be on the lower end. RSU’s as mentioned earlier don’t provide dividends. Some provide dividend equivalent payments. Those are slightly different and RSU’s aren’t considered, you know, employee’s property. So, again, circling back to that vesting right requirement. And for RSU’s, no voting rights.

Cassidy Clement

Yeah, right. So, it’s just the trade-off. So, centrally, like with that, that tangible property piece— you can’t really pay the tax before the vesting period. And that’s the one item line that I think a lot of people don’t always think about when it comes to these types of, whether you want to call them grants, plans, options, etc.— is once they become yours, it’s great, but you still have to make sure that the taxation that’s implicated on you is able to be covered. And that, kind of, is the area here where some people are like, ‘there’s a real nice chunk of change coming my way.’ But you can’t pay that tax until it becomes yours. And you also don’t know what the markets going to be like. So, your taxation that comes in—the market could be swinging way high and it’s going to be a big bill, or you get a bearish day. And you know, it’s not as much of a punch to the wallet as some of the others, but I know we covered some of the cash versus shared cash versus taking out taxes from shares here today. But I think for an easy intro and understanding some of the different aspects and facets of stock vesting, this will be helpful for our listeners. So, thank you for joining us.

Barbara Olander

It was a pleasure.

Cassidy Clement

And listeners can learn more about an array of financial topics for free at any time at IBKRcampus.com. Thanks for listening everyone!

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