# Understanding Stock Compensation: Definition, Usage, and Vesting

## What Is Stock Compensation?

Stock compensation is a way corporations use [stock options](https://www.investopedia.com/terms/s/stockoption.asp) to reward employees. Employees with stock options need to know whether their stock is vested and will retain its full value even if they are no longer employed with that company. Because tax consequences depend on the [fair market value (FMV)](https://www.investopedia.com/terms/f/fairmarketvalue.asp) of the stock, if the stock is subject to tax withholding, the tax must be paid in cash, even if the employee was paid by [equity compensation](https://www.investopedia.com/terms/e/equity-compensation.asp).

### Key Takeaways

*   Startups commonly use stock compensation as a tool to attract and retain talent when cash resources are limited, allowing employees to share in the company’s growth and success.  
    
*   Stock compensation usually comes with a vesting schedule, often spanning three to four years, requiring employees to fulfill certain service or performance obligations before earning the stock fully.  
    
*   There are different types of stock compensation, such as non-qualified stock options (NSOs), incentive stock options (ISOs), restricted stock units (RSUs), and performance shares, each with unique characteristics and tax implications.  
    
*   Exercising stock options allows employees to purchase shares at a predefined price, which can be done using different methods, though restrictions typically apply, especially in private companies.  
    
*   RSUs and performance shares help motivate and reward employees based on the achievement of specific performance metrics or time-based criteria, contributing to a performance-driven culture.

## Understanding the Mechanisms Behind Stock Compensation

[Startups](https://www.investopedia.com/terms/s/startup.asp) often use stock compensation as they may not have the cash to offer competitive salaries. Executives and staff may share in the company’s growth and profits that way. However, many laws and compliance issues must be adhered to, such as [fiduciary duty](https://www.investopedia.com/ask/answers/042915/what-are-some-examples-fiduciary-duty.asp), tax treatment and deductibility, registration issues and expense charges.

When [vesting](https://www.investopedia.com/terms/v/vesting.asp), companies let employees purchase a predetermined number of shares at a set price. Companies may set vesting for a specific date or on monthly, quarterly, or annual schedules. The timing may be set according to company-wide or individual performance targets being met, or both time and performance criteria. Vesting periods are often three to four years, typically beginning after the first anniversary of the date an employee became eligible for stock compensation. After being vested, the employee may [exercise their stock-purchasing option](https://www.investopedia.com/terms/e/exercise.asp) any time before the expiration date.

## Practical Example of Stock Compensation in Action

For example, assume that an employee is given the right to purchase 2,000 shares of stock at $20 per share. The options vest 30% per year over three years and have a term of five years. The employee pays $20 per share when buying the stock, regardless of the [stock price](https://www.investopedia.com/articles/stocks/08/stock-prices-fool.asp), over the five-year period.

## Exploring Different Types of Stock Compensation

There are different types of stock compensation, such as [non-qualified stock options (NSOs)](https://www.investopedia.com/terms/n/nso.asp) and [incentive stock options (ISOs)](https://www.investopedia.com/terms/i/iso.asp). ISOs are only available to employees and not non-employee directors or consultants. ISOs offer special tax advantages. With non-qualified stock options, employees are required to pay income tax based on the grant price minus the price of the exercised option.

[Stock appreciation rights (SARs)](https://www.investopedia.com/terms/s/sar.asp) let the value of a predetermined number of shares be paid in cash or shares. [Phantom stock](https://www.investopedia.com/articles/stocks/12/introduction-phantom-stock.asp) pays a cash bonus at a later date equaling the value of a set number of shares. [Employee stock purchase plans (ESPPs)](https://www.investopedia.com/articles/stocks/12/employee-stock-purchase-plans.asp) let employees buy company shares at a discount.

### Understanding Restricted Stock and RSUs

Restricted stock and [restricted stock units (RSUs)](https://www.investopedia.com/terms/r/restricted-stock-unit.asp) allow employees to receive shares after specific years or performance goals. [Restricted stock](https://www.investopedia.com/articles/financial-advisors/110915/restricted-stock-units-what-know.asp) requires the completion of a vesting period. This may be done all at once after a certain period of time. Alternatively, vesting might be equally distributed over years or in any way management chooses.

RSUs are similar, but they represent the company's promise to pay shares based on a vesting schedule. This offers some advantages to the company, but employees do not gain any rights of stock ownership—such as [voting rights](https://www.investopedia.com/ask/answers/040315/what-can-shareholders-vote.asp)—until the shares are earned and issued.

### Performance Shares: How They Motivate Key Employees

Companies award [performance shares](https://www.investopedia.com/terms/p/performanceshares.asp) to executives and managers only if certain specified measures are met. These could include metrics, such as an [earnings per share (EPS)](https://www.investopedia.com/terms/e/eps.asp) target, [return on equity (ROE)](https://www.investopedia.com/terms/r/returnonequity.asp), or the total return of the company's stock in relation to an index. Typically, performance periods are over a multi-year time horizon.

## Steps to Exercise Your Stock Options

Stock options may be exercised by paying cash, exchanging shares already owned, working with a stockbroker on a same-day sale, or executing a [sell-to-cover](https://www.investopedia.com/terms/c/cover.asp) transaction. However, a company typically allows only one or two of those methods. For example, private companies typically restrict the sale of acquired shares until the company [goes public](https://www.investopedia.com/terms/g/goingpublic.asp) or is sold. In addition, private companies do not offer sell-to-cover or same-day sales.

> **Article Sources**
>
> 1.  Internal Revenue Service. "[Publication 525: Taxable and Nontaxable Income](https://www.irs.gov/publications/p525#en_US_2019_publink1000229106)."
>     
> 2.  Fidelity. "[Incentive Stock Options (ISOs)](https://www.fidelity.com/viewpoints/wealth-management/insights/incentive-stock-options)."