What Are Types of Equity Compensation? Definition and Benefits

Equity compensation, or stock-based pay, lets employees own a part of a company instead of getting cash. Start-ups and public companies use these plans to improve their pay packages. Knowing how equity works helps you attract and keep top talent while saving cash flow.

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Types of equity compensation

It’s important to identify your specific type of stock-based compensation to fully understand its benefits and potential challenges. Here are some common types of equity compensation:

Stock options

Stock options let employees buy company shares at a set price after a certain period. They can be either Incentive Stock Options (ISOs) with tax benefits or Non-Qualified Stock Options (NSOs) with different tax implications.

Restricted stock units (RSUs)

RSUs are given to employees for free and become actual shares after a vesting period. They are taxed when they vest and are sold, providing a safer way to gain equity.

Stock appreciation rights (SARs) & phantom stock

These awards give employees compensation based on the company's stock performance without granting actual stock ownership. Employees can receive cash or stock equivalents after the vesting period.

Performance shares

These shares are awarded when employees meet specific performance targets. Often given to executives, they incentivize achieving certain company goals.

Employee stock purchase plans (ESPPs)

ESPPs allow employees to buy company stock at a discounted price, usually 5-15% off the fair market value. Contributions are deducted from paychecks, and taxes depend on the type of ESPP.

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How does equity compensation work?

Offering employee equity compensation can be complex. These plans grant employees the right to purchase company stock at a fixed price, providing potential tax benefits and a direct ownership stake in the company.

Vesting schedules dictate when employees can claim their equity, often requiring them to stay with the company for a set period or meet specific performance targets. Exercising stock options allows employees to buy shares at a predetermined price that potentially leads to favorable tax consequences and encourages long-term commitment.

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Cash vs equity compensation

Cash compensation is straightforward to understand. Employees receive a fixed salary or cash payment regularly, which directly affects the company's cash flow and does not involve complicated tax rules like stock-based compensation.

Unlike cash, equity compensation offers potential long-term benefits tied to the company's stock price. This can include different types of equity, like restricted stock units and employee stock purchase plans, each with its vesting schedule and tax advantages, rewarding employees when performance targets are met.

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Why offer equity compensation?

Offering equity compensation plans is a strategic move for both employers and employees. For employers, it enables them to reward key employees with company stock or equity-based compensation without impacting cash flow, which is especially beneficial for startups investing in growth.

For employees, receiving equity awards like restricted stock units or participating in an employee stock purchase plan can be financially rewarding as the company shares increase in stock price and improve the overall benefits package.

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Equity compensation pros and cons

Offering equity incentives has its pros and cons for employers and employees alike.

Pros

• Helps attract and keep talent, especially for smaller businesses competing with larger firms.

• Aligns employees' interests with the company's goals, fostering a sense of ownership.

• Employees with equity awards tend to work harder as their performance directly impacts their earnings.

• Can boost team spirit, making employees feel like owners who can influence the company's direction.

• Both the employer and employee can enjoy tax benefits from specific ownership compensation plans.

Cons

• Employees might face a higher alternative minimum tax.

• Understanding different types of ownership compensation and their tax implications can be complicated.

• The fair market value of company shares can fluctuate, posing a financial risk to employees.

• Companies must adhere to strict regulations by the Securities and Exchange Commission (SEC) when offering equity compensation.

• Employees must wait through the vesting schedule to fully own their equity, which can be a long process.

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FAQs

Let's answer some frequently asked questions about equity compensation.

What is the risk of equity compensation?

The value of employee equity can fluctuate which means investing involves risk. Company executives and employees should be aware that they may need to pay taxes on equity awards and ordinary income, and they might face potential losses if the company shares do not perform as expected.

Does equity compensation count as income?

Yes, equity incentives count as income and are subject to income taxes. When employees receive equity awards such as restricted stock units or incentive stock options, the value of these awards is considered part of their compensation package.

How do you determine the amount of employee equity to offer?

To determine the amount of employee equity to offer, you need to consider the size of your equity compensation plan, which typically accounts for 10-20% of the company’s total equity. Then, assess the valuation of the options based on the most recent capital raising round, and customize the equity award to the role and tenure of each employee, recognizing that early team members often receive larger allocations.