Here’s the main benefit of receiving employee equity compensation: It has the potential to bolster your long-term financial goals.

Yes, potential.

You’ll be reading that word a lot throughout this article. We’ll discuss why.

Given the rise in popularity of equity as a form of employee compensation — and thus, as a potential portion of your wealth — it’s important to know the basics of popular forms of equity compensation.

Equity compensation can be complex. But with the right knowledge and a clear strategy in place, you may be able to leverage your equity compensation within a comprehensive financial plan to meet your goals even sooner than you may have planned.

Let’s dig in.

What is employee equity compensation?

Employee equity compensation is a form of non-cash compensation that gives you partial ownership in your company.

Both startups and established companies offer equity compensation for myriad reasons. One of the more common purposes is to free up cash flow by offering this alternative form of compensation instead of cash. Another driver is attracting high-quality talent — and then keeping those people motivated to both achieve performance goals and remain employed with the company.

Main types of equity compensation

There are generally three types of equity compensation awarded to employees:

1. Stock options
2. Employee stock purchase plans
3. Restricted shares

Each type of compensation has unique characteristics, so it’s important to identify your type of equity compensation so you can understand its benefits and potential challenges.

Stock options

With stock options, employees have the right — but not the obligation — to purchase company stock at a predetermined exercise price. Types of stock compensation options generally can be categorized as either incentive stock options (ISOs) or non-statutory stock options (NSOs), which are sometimes also known as non-qualified stock options (NQOs).

The biggest difference between these two types is their tax treatment. NSOs are taxed as ordinary income when an employee exercises them. If the shares are held for more than one year after exercise, they can be sold at preferential long-term capital gains rates. ISOs are a bit more complex but can have potential tax benefits depending on when they’re exercised and how long the shares are held before sale. Exercising ISOs may or may not cause the alternative minimum tax to apply, but if the shares are held for more than two years after grant and more than one year after exercise, they can be sold at long-term capital gains rates, which are typically lower than ordinary income rates.

Employee stock purchase plans

In an employee stock purchase plan (ESPP), employees can buy company stock, usually at a discount. Employees contribute to the ESPP via payroll deductions. On certain dates, the company will use the funds in the ESPP to purchase shares for the employees, often at a discount of 5% to 15%. If the shares are held more than two years after grant and more than one year after purchase, they can be sold at long-term capital gains rates. That can be a nice tax benefit, but in some cases it can also make sense to just sell shares as soon as possible and capture a guaranteed discount.

Restricted shares

Restricted shares (in the context of equity compensation) are usually structured as either restricted stock units (RSUs) or restricted stock awards (RSAs). Unlike with other types of equity compensation, employees don’t have to buy them — they simply receive the shares as compensation. Companies usually grant RSUs on a vesting schedule that’s tied to either a particular amount of time with the company or certain performance milestones. An employee doesn’t get any tangible value from the shares until they’re vested. When RSUs vest, their value is considered ordinary income.

What’s the value of employee equity?

When considering the true value of employee equity, you are often in a speculative position. Sure, you have the possibility of coming into a windfall like Katie. But keep in mind that you’re also placing a bet on the same company that also signs your paycheck. The biggest risk comes if most of your net worth is tied up in your equity.

Rather than let company stock dominate your portfolio, part of managing your wealth is figuring out how (and when) to:

1. Sell down some of your shares in a tax-efficient manner.
2. Build a diversified portfolio appropriate for your risk tolerance and financial goals.

It’s important to understand your awards, vesting schedule, potential tax consequences and concentration risk within your overall allocation. The more information you’re armed with, the better you know what your equity compensation could ultimately be worth — potentially.