What Is Equity Compensation?

If you’re thinking of offering equity compensation to existing employees or new hires, it’s a form of payment that should make you both excited and wary.

That’s because while equity compensation options check a lot of boxes—they're a great way to attract talent and provide an opportunity to be generous if you can't pay top dollar—they take time and resources to set up properly.

Equity compensation is a form of payment that both public companies and private firms sometimes offer employees. Also called employee equity, equity compensation involves employees investing in their own company as compensation for their work. Stock options and restricted stock units are a common form of equity compensation.

Whether an employee will be excited about receiving equity compensation depends on how they feel about your company. That’s because equity compensation can be profitable or a dead end, depending on the future health of the company.

Equity compensation: Key facts

• Equity compensation is a form of non-cash payment given to employees.
• There are numerous ways to pay an employee, including stock options and performance shares, both of which give some type of ownership to company employees.
• Equity compensation is designed to motivate employees to work hard and make more money for themselves and the company.
• Sometimes, people will receive equity-based compensation plans on top of a robust salary. But often this is a form of payment that startups may offer when they hire new employees, to make up for an uncompetitive salary.

How does equity compensation work?

Employee equity compensation is non-cash pay and often consists of some type of company stock.

These are a few terms to get acquainted with:

• Vesting schedule: This refers to the timeline when an employee can take the options or shares they were promised when they agreed to equity compensation.
• Exercise price: Sometimes called a strike price, the exercise price is the price that a company stock or asset can be purchased or sold for, once vesting requirements have been met.
• Purchase date: This is a term often used with ESPP plans (employee stock purchase plans). On the purchase date, employees buy company shares at a discounted rate.
• Set price: This usually refers to the price at which employees can buy company stock; generally, at below-market value prices. If the company’s stock value goes up, the employee stands to make significant money.
• Grant date: This is the day employees receive stock options, giving them the right to purchase stock at an already agreed-upon price.

Until employees follow the vesting schedule and turn a company's shares into money, equity compensation is a form of deferred compensation. There is a risk to the employee in accepting this type of payment. If the company fails, employees won't see profits.

That said, an equity compensation plan has numerous benefits for both the employees and the employers.

Benefits for employees

• Potential tax benefits. You’ll want employees to talk to a tax accountant to avoid tax consequences, but there can be tax advantages to accepting this equity compensation. For instance, if they accept incentive stock options, or ISOs, as a form of payment and wait to sell them (usually a few years later), they may have them taxed as long-term capital gains instead of ordinary income. That can mean they'll pay substantially less in taxes.
• A sense of ownership in the company. Nobody likes to think that the harder they work, the richer somebody else becomes, but it's different when employees also have a stake in the company. They know that the more effort they put into their job, the wealthier they will be later (at least in theory).
• More wealth overall. If the employee is working for a well-run operation, and the company's direction is trending toward growth, receiving equity shares could make them more wealthy than they would have been with a higher paycheck or annual bonuses.

Benefits for employers

• Possible tax benefits. For instance, employer contributions to employee stock ownership plans are deductible, up to 25% of the payroll.
• Your cash flow should benefit. Instead of paying top dollar for talent, you may be able to pay a bit less and still attract the best employees.
• More committed employees. They now have an ownership stake in the company.

When should a company offer equity compensation?

There are several reasons why a business owner may want to consider offering an ownership stake in their company. A few common scenarios include the following:

You’re hiring and trying to attract the best and brightest

Startups and other companies poised for high growth may not have the cash flow or deep pockets to offer competitive salaries compared to established companies. Offering incentives such as stock options and company shares can help. These are employee benefits that may attract top-tier talent.

You’re transitioning business structures

If, for example, your private company is preparing to go public, offering equity compensation plans could ensure integral employees are committed to the company’s success. You might also motivate them to reach particular performance targets through the transition period and beyond.

You want to reward and motivate your employees

There’s nothing wrong with simply showing that you value employees and want to give them a stake in the company.

Types of equity compensation

There are many ways you can give an employee company stock. Here’s a quick rundown of the types of equity compensation a business may offer:

Incentive stock options (ISOs)

ISOs allow employees to buy shares of the company stock at a discounted price. ISOs require a vesting period of at least two years, followed by a holding period of over a year before they can be sold.

Non-qualified stock options (NSOs)

A non-qualified stock option (NSO) is a type of employee stock option. Simply put, the employee gains equity in the company, and they can buy shares in the company at a discounted price. The appeal is that the shares will appreciate in value if the company does well.

Restricted stock

These are nontransferable shares of the company issued to employees. They can sell them, but usually not for several years. They have no value until the shares have vested or specific performance-related goals have been met.

Restricted stock units (RSUs)

Restricted stock units (RSUs) are similar to restricted stocks. Generally, restricted stocks have more rules; they're typically granted to executives, while lower-rung employees will get RSUs.

Restricted stock awards

In this case, employees get the stock upon joining the company and become shareholders with voting rights. That said, employees must follow vesting requirements before selling and taking the cash equivalent of their assets.

Performance shares

This, too, is a form of stock. It’s incentive-based, where the company stock can be sold when certain benchmarks, performance targets, or milestones are met within the company.

Employee stock purchase plans (ESPPs)

In this case, the employee sets it up so they can purchase shares of the company on a regular basis. A small amount comes out of every paycheck to purchase ESPPs, often for a discount. If the company does well, then the employees will benefit, too.

Phantom stock

This offers the benefits of stock ownership without giving employees ownership in the company. Employees will get something called "mock stock." The phantom stock goes up with the company's stock price, and employees get profits. So, while the employees may not "own" the company, the harder they work, the more money they make.

Stock appreciation rights

This is a form of stock-based compensation that's similar to phantom stocks and stock options. However, the employee doesn't need to pay an exercise price to get the value of the stocks. They'll earn the net amount of the increase in the stock price in cash or shares of company stock.

The role of an attorney in equity compensation

Just as you wouldn’t buy or rent a commercial office without a real estate agent, you don’t want to offer an employee partial ownership in your company without the help of an experienced corporate attorney who is well-versed in securities law and employment law. Every business owner thinking of offering stock options needs a legal counselor who can navigate the regulatory requirements, reporting, and tax laws associated with different types of equity awards.

If you don’t use an attorney to set up equity compensation plans, you run the risk of inadvertently committing fraud and having the Securities and Exchange Commission (SEC) investigate your company. Or you could become the subject of a civil lawsuit by a disgruntled employee who argues that the equity-based compensation wasn’t set up properly.

Equity compensation challenges

In the long run, giving personnel some ownership in the company, such as employee stock options, can benefit both the employer and the employee. In the short term, there are plenty of potential headaches for anyone trying to get this form of payment in motion:

• Increased administration work. Managing these complex plans takes resources, and your employees will have questions related to everything from income tax to shareholder value. You’ll need somebody in HR who can answer those questions.
• What if your company doesn’t do well? Your executives will soon notice that their financial benefits aren't worth much. If things get bad enough, you could see company morale plummet, which could depress work turnout and the bottom line.
• Staying compliant. If you’re not on top of payroll and tax regulations, you could have some serious problems later. For instance, startups typically need to undergo a 409A valuation before they can offer equity-based compensation. That’s a process that decides the fair market value of private companies' stock value. Without the 409A valuation, you could find yourself in legal hot water and in trouble with the Internal Revenue Service (IRS). A capable corporate attorney will be able to steer an employer clear of any problems.

FAQs

What should companies consider when setting up an equity compensation plan?

There is a lot for a business owner to consider, such as whether they are comfortable giving up some control of the ownership of their business to key employees. Beyond that, who is going to structure this equity compensation plan so that it’s fair and within the parameters of the law? Offering actual stock in a company isn’t something any business wants to rush into. There are a lot of financial considerations you'd want to discuss with your corporate attorney first.

What happens to my equity compensation if I leave the company?

If you're an employee who leaves before your shares are vested at the end of a specified period—that is, before you’re allowed to sell shares of your stock—you will probably end up losing those shares when you leave the company. That’s why anyone should think long and hard about whether they want to engage in equity compensation work. But it's also why employers offer it. They want to motivate employees to work hard for the company but also to stick around for a few years and keep turnover from being too high.

How does a company decide how much equity to offer an employee?

There’s no one right way to decide how much equity to offer an employee. As a general rule of thumb, many companies will put aside anywhere from 5% to 20% of their company shares toward equity compensation, with no employee receiving more than 3% of the shares. It’s important, however, to discuss these employee benefits with your corporate attorney, your CFO, and other key company executives. Many factors go into play, including the talents your employees bring to the company and how fast you believe your firm will grow.

How is equity in a company paid out?

It depends on what non-cash assets the employee will be given, and there are a lot of types of equity compensation. They might be receiving employee stock purchase plans (ESPPs) or a phantom stock. Usually an employee will be paid in some type of company stock and will have to wait several years before the stock is vested. Only then can they sell it.