Equity compensation, also known as stock-based compensation, is a type of non-cash pay that a company offers to employees to partake in stock ownership of the firm, such as options, restricted stock and performance shares.
Here’re its benefits for both employers and employees:
- Attracts and retains talent: It is particularly useful for smaller companies that are just starting out, allowing them to offer employees a portion of their potential when they don’t have much cash to hand.
- Attains greater alignment: Employers benefit from aligning their employees’ values with the company’s missions.
- Achieves lower absenteeism: Employees are more productive as their performance impact how much they can earn.
- Builds employee engagement: Employees likely generate a feeling of team spirit – they’re not just employees, they’re employee-owners and can often make valuable contributions to the company’s direction.
- Helps cash-flow management: Equity compensation reduces the amount paid out in cash, especially ideal for companies with limited cash flow.
- Provides tax benefits: Employees can enjoy tax benefits from some approved plans.
- Offers significant financial benefits: Employees can reap a huge benefit from their equity if the company succeeds. This benefit will be much more significant than cash.
Types of equity compensation
Employee equity compensation comes in a wide variety of forms and plans. The following five types are broadly used by companies.
- Stock Options – Incentive stock options (ISOs) & Non-qualified stock options (NSOs)
- Restricted Stock – Restricted stock units (RSUs) & Restricted stock awards (RSAs)
- Cash Deferred Bonus Plans – Stock appreciation rights (SARs) & Phantom stock
- Performance Shares
- Employee Stock Purchase Plans (ESPPs)
How does each equity compensation type work?
Equity compensation works by offering employees an equity award where they have to stay with the company for a certain amount of time before earning full ownership of the stock. Let’s see how the following types of equity-based compensation work:
1. Stock options – Incentive Stock Options (ISOs) & Non-Qualified Stock Options (NSOs):
A stock option is a popular equity compensation form. It provides employees with the right, but not the obligation, to purchase company shares at an initially agreed price (i.e. exercise price) after a vesting period. Vesting is a process of earning full ownership of your award.
Tax Events: There’re two main types of stock options – ISOs and NSOs. An option holder doesn’t have tax liability when an option is granted and vests. However, with NSOs, you’re taxed when you exercise and sell them. With ISOs, you’re only taxed when they are sold. (Notes: Alternative minimum tax (AMT) may be chargeable when you exercise your ISOs.)
Pros & Cons:
Pros: Employees can benefit from the increase in value of the company. The vesting schedule can be customized flexibly. There’re also tax benefits with ISOs as only favorable long-term CGT is charged at sale when you sell your shares at least 2 years from the grant date and at least 1 year from the exercise date.
Cons: Employees need to pay tax when exercising NSOs. No matter whether it’s an ISO or NSO, options can potentially be worthless when their value drops below the exercise price.
Suitable for many companies – early stage, high growth startups and publicly traded companies. Employers can issue employee stock options broadly or with a group of selected employees. NSOs would be an ideal choice if you wanted to offer stock options to non-employees or to offer simple stock options with fewer restrictions.
2. Restricted stock – RSU & RSA:
Restricted stock is a type of equity compensation with less risk. He/she earns the shares after vesting requirements are met. Participants may need to pay for the grants under RSA plans while they typically receive the grants for free under RSU plans.
Tax Events: Your RSUs will potentially be taxed when you vest and sell them. With RSAs, you’ll be taxed at the time of grant and sale under section 83b election rules.
Pros & Cons:
Pros: As employees don’t need to pay for RSUs, they carry less risk and will always have value as long as the company stock price stay above $0. Like options, their vesting schedule is flexible.
Cons: Employees can’t control the timing of taxation with RSUs as ordinary income tax is due once they vest while they can with NSOs.
Suitable for many companies who want to offer equity broadly or with a group of selected employees without requiring payment upfront. (RSA is commonly used by startups while RSU is by established companies)
3. (Cash) deferred bonus plans – SARs & Phantom stock:
A deferred bonus is an equity form that doesn’t really use stock but still rewards employees with compensation that is tied to the company’s stock performance. So, participants are not shareholders and don’t have voting rights.
Your award depends on the appreciation of the stock value or the full stock value. Once the vesting period is over, participants can get a cash equivalent or the actual stock (less often).
Tax Events: You’ll potentially be taxed when you exercise and sell your award.
Pros & Cons:
Pros: Like RSUs, employees usually don’t need to pay for their SARs/Phantom stock, meaning they just simply receive the awards for free. They can be paid out in cash or company stock. If settled in cash, it will avoid the dilution of the ownership.
Cons: There is a straight cash outlay for the company if settled in cash. This form also allows for flexible vesting design.
Suitable for many companies who want to offer employees compensation without requiring employees’ upfront payment and issuing a large number of extra shares.
4. Performance Shares
Performance shares will vest when employees meet specific performance-related goals.
Pros & Cons:
Pros: It helps companies achieve financial and other strategic goals.
Cons: If the targets are too hard to achieve, employees could lose morale.
Suitable: These awards are frequently allocated to company executives and directors as an incentive to achieve particular performance targets.
5. Employee stock purchase plans (ESPPs):
Commonly used by public companies who want to attract, retain, and/or motivate employees, ESPPs allow participants to purchase stock in their companies at a discount – often between 5-15% off the fair market value.
ESPPs work by making contributions from employees’ paychecks (after-tax dollars) over some time. Their accumulated contributions are used to buy company shares at the purchase date.
Tax Events: For non-qualified ESPP, you’ll be taxed when you purchase and sell your shares. For qualified ESPP, you’ll only be taxed when you sell your shares.
Pros & Cons:
Pros: It has tax benefits for employees (for qualified ESPP). Employees can also buy the shares at a discount of up to 15%. Some companies offer an ESPP lookback feature which allows employees to enjoy a lower purchase price, giving an extra benefit.
Cons: There’s a cap on contributions
Suitable for publicly held companies who want to share equity broadly or with a group of selected employees.
How much employee equity to offer?
Startups typically create employee equity plans that comprise 10–20% of the total equity of the company (50% for the founder(s) and 30-40% for investors). It’s similar to what David Steinberg – the founder of Zeta International, a strategic marketing company – recommended to us: Steinberg recommends establishing a pool of about 10% for early key hires and 10% for future employees.
Potential problems with equity compensation
Although equity compensation is popular in different industries, there’re some downsides:
- Share dilution to existing shareholders
- A lot of reporting and regulations to follow, as well as entire areas of jurisdiction and tax laws
- The design process of equity compensation requires a tremendous amount of work and thought, e.g. how much equity to give away, participant eligibility, vesting schedule, period of the plan
- It may also cause extra equity plan administration workload to your existing departments – everything from tracking and reporting changes in ownership to updating documents/policies/procedures, communicating with stakeholders, consulting your board of directors, and staying compliant. So, companies tend to outsource their equity compensation management.