Equity compensation is a type of payment that employers offer employees. It can come in the form of shares of ownership in the company, rights to shares of ownership, or cash incentives based on the current share prices of the company.
Understanding How Equity Compensation Works
Equity compensation is when a company gives its workers extra pay in the form of shares of ownership in the company. It is also called share-based compensation, and it comes in many different forms, such as stock options, restricted stock (RSU), and employee stock purchase plans.
Employees who are paid with shares of ownership can later sell those shares on the private or public markets.
For instance, a startup might try to hire top people by giving them a good salary and options to buy stock in the company. This is good for both the employee and the employer. If the shares go up in value, the employee will make money, and the employer will be able to offer non-cash incentives to attract top talent and lower its immediate payroll obligations.
When a company gives its employees equity compensation, it means that along with their salary, the employees also own private or public shares of stock. Most of the time, employees have to work for the company for a certain amount of time before they are fully vested in the shares, which means they own the stock in full. If a company is privately owned or owned by the public, employees who have fully vested can take their shares of stock and sell them on private or public markets for cash.
There are several reasons why a potential employer could offer equity pay to prospective employees.
1) To reduce the amount of cash needed
By giving their employees ownership in the company, businesses can save money on payroll costs right away. This is especially popular with new businesses that don't have limited cash flow.
2) Fixing the problem of "principal/agent"
This happens when workers don't have the same reasons as the boss to always do what's best for the company. By giving employees equity-based pay, they can become part-owners of the business, which brings their interests closer to those of the company's executives and owners.
3) Hiring and retention
Equity compensation can make it easier to hire and keep good employees because it creates a financial tie between the employee and the company.
Note: Even though giving employees shares of a company reduces an employer's cash needs at first, the employer usually ends up paying for it. This is because the price per share goes down as more shares are given to employees. Also, if the company is bought or goes public, or if an employee sells their shares after they are fully vested, the employer will own less of it.
Types of Equity Compensation
Equity compensation plans come in a wide variety of forms, each with its own set of contractual obligations for the employees. Here are some of the most popular types of equity compensation plans:
- Stock Options
- Restricted Stock Unit (RSU)
- Employee Stock Purchase Plans
- Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs)
- Phantom Stock
- Stock Appreciation Rights
Businesses that provide equity compensation might grant stock options to employees, which allow them the opportunity to buy shares of the company's stock at a predetermined price (also known as the exercise price). After serving the company for a specific amount of time, this option may eventually vest, giving employees ownership of it. They acquire the right to sell or transfer the option after it has vested. By using this strategy, employers can build long-term employee loyalty. Make a note that this choice often has a deadline.
When this option is given to employees, they are not considered stockholders and do not have the same rights as stockholders. There are different tax rules for options that have been exercised and options that have not been exercised, so employees need to find out what tax rules apply to them.
Restricted Stock Units (RSU)
Restricted stock, also called RSUs (short for "restricted stock units"), is when an employee is given shares of stock but only has limited rights to own them. Limits on who owns the stock usually come in the form of a vesting schedule. During this time, the employee doesn't fully own the shares until they've worked for a certain amount of time or met certain performance goals. After the employee gets full ownership of the shares, those shares give the employee full voting and dividend rights.
Employee Stock Purchase Plans (ESPPs)
Employee stock purchase plans (ESPPs) let workers buy stock at a discount, usually up to 15% off, with money taken out of their paychecks after taxes. Depending on the rules of the ESPP, most of the time all employees can buy stock at a discount.
Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs)
Non-qualified stock options (NSO) and incentive stock options (ISOs) are also forms of equity compensation (ISOs). ISOs can only be used by employees (and not non-employee directors or consultants). These choices have special tax benefits. For example, when employees get non-qualified stock options, their employers don't have to report when they get them or when they can be used.
Phantom stocks are contracts that give employees the right to cash payments based on the value of the company's shares on the market at a certain time or under certain conditions. Phantom stock is not made up of real company shares. Instead, it is based on the price of the company's shares.
Stock Appreciation Rights (SARs)
Stock appreciation rights are a type of pay that lets employees profit from the rise in value of a certain number of shares of company stock over a certain period of time. SARs are like stock options, but they don't have to be exercised at a fixed price like stock options do.
The Advantages and Disadvantages of Equity Compensation
1) It aligns with the financial incentives for employees with the success of the company
If employees have a stake in the organization's success, they are more likely to act in the best interests of the business. If an employee helps the firm grow, their financial well-being will improve because their net worth is associated with the company's performance.
2) It gives the employee a chance to save money on taxes
Employees who get stock as part of their pay will have to pay taxes on the value of the stock on the day they are fully vested. But they don't have to pay taxes on any increase in the shares' value up to that point. Also, there is no cost to sell the shares for cash.
3) It helps companies find and keep the best employees
Businesses that offer equity-based compensation plans have a bargaining chip to attract and keep the best employees as the company grows. This is because most equity-based compensation plans have rules about when employees can start to get their shares.
The Disadvantages of Equity Compensation
1) When companies offer equity compensation plans, they have to give up their ownership
When companies offer equity compensation plans, the owners often have to pay a price by giving up some of their ownership. This hurts their overall financial incentives and profits if they ever decide to sell the company.
2) Equity compensation plans show up on the income statement as a non-cash expense, which lowers the value of the company
Even though offering equity compensation plans can reduce a company's need for cash, it still shows up as a non-cash incentive on the income statement, which affects the value of the company.
3) It reduces the value of the shares that already exist
The more shares of stock that a company offers, the more it reduces the value of all of the other shares that are already.
Investors should think about how a company pays and rewards its employees when deciding which companies to add to their portfolios. This is because how a company pays and rewards its employees may affect how to value the company and if it fits their investment goals and portfolio standards. For example, if a company is having trouble making money and also owes money to its employees because of equity compensation plans, this could hurt the company's balance sheet in the future and is something that investors should be aware of.
Also, how a company pays its workers can affect the culture of the company as a whole. From an investing point of view, it's important to know that a company's culture can be a great sign of how healthy it is.
If this is something you are considering but are not sure how to start, speak with one of our advisors at Vincere Wealth. We would be happy to help you formulate a strategy that is tailored specifically to your needs.
Don’t forget to check out:
- Understanding the Employee Stock Purchase Plan (ESPP)
- An Overview of Incentive Stock Options (to be added)
- Understanding How Restricted Stock Units Work (to be added
- 6 Biggest Myths of Investing
I hope this information was helpful. If you have any questions, feel free to reach out. I’d be happy to chat with you.
About the Author
As Managing Partner of Vincere Wealth, Josh assists clients in navigating financial challenges and making sound financial decisions. Having someone guide you in making sensible financial decisions today can have a substantial impact on your future financial wellbeing. Josh takes great pride in guiding customers through the complexities of taxes, real estate, businesses, employer stock, and international financial planning.
If you're interested in an investment advisory or financial planning relationship, please consider Vincere Wealth Management.
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