Equity Compensation: How It Works and How to Implement It
Offering equity compensation can make you more competitive as an employer. Learn about the different types of equity compensation plans, their benefits, and how to set up a plan for your company.
Published on June 1, 2023
What is equity compensation?Equity compensation is a form of non-cash payment that grants your employees partial ownership of your company through stock shares. You can either grant employees these shares of stock or give them the option to purchase shares at a discounted rate. Usually, companies don’t give employees stocks immediately upon hiring them; instead, there’s often a vesting period or vesting schedule involved. Under a vesting schedule, employees earn their stock options or shares over a set period of time instead of all at once. For example, with a four-year graded vesting period, employees would receive 25% of their promised equity compensation after one year. Vesting periods help retain employees for longer periods of time, encouraging people to stay with the company at least until their stocks fully vest. After equity vests, employees have full ownership and rights to their stocks or stock options — the right to purchase shares. If employees hold onto their shares, they’re eligible to earn dividends based on the company’s profits or performance on the stock market. Otherwise, employees can choose to sell their shares just as they could any other stocks they own.Some companies may offer equity as part of their total employee compensation package as a way to offset a lower base salary. But that’s not always true — you can offer equity compensation as a way to boost your total comp even further and competitively attract top talent.
Types of equity compensation plansThere are many different ways to offer your employees a piece of the company. Each type of equity compensation offers its own benefits and downsides that you should weigh when deciding which pay strategy is best for your organization.
Incentive stock options (ISOs) and non-qualified stock options (NSOs)Offering your employees and contractors stock options allows them to purchase shares of the company at an exclusive, discounted rate below fair market value. Stock options are a great way to give employees access to profits, adding a tidy bonus to their total compensation. The two main kinds of stock options are incentive stock options (ISOs) and non-qualified stock options (NSOs), with ISOs being more valuable due to favorable tax treatment. Incentive stock options give employees the ability to buy a set amount of shares at a certain price based on how long they’ve been at the company. This price — also known as the exercise price — is predetermined and is usually below the market rate. Employees with ISOs can purchase shares at this lower rate, then sell for a tidy profit if the stock appreciates in value. Because of their high value and tax benefits, ISOs are often only made available to top performers, executives, and managers. Companies may require that employees work there for a certain period of time before exercising their stock options. You might also restrict ISOs to those who complete specific sales or performance goals. Non-qualified stock options work similarly to ISOs but don’t come with their preferential tax treatment or hefty list of restrictions. By offering NSOs, you provide workers with the benefits of purchasing stock at a lower price and increasing their income without the strings that come attached to ISOs. In contrast to employee-only ISOs, you can offer NSOs to contractors, vendors, partners, consultants, and more, bolstering your nonemployee compensation. Arguably the biggest advantage of offering NSOs instead of ISOs is that employers can claim a tax deduction on the profits declared by holders of NSO shares. This deduction can be especially beneficial to your company if your company stock is highly profitable.ISOs offer exclusive tax advantages to employees willing to invest time and effort into the company. Employees who receive ISOs can defer tax payments on their earnings until after they sell their shares of stock. Income earned from ISOs can also be taxed as long-term capital gains, which results in lower tax rates than the ordinary income tax rate. However, while holders of ISOs only pay taxes on their stocks when they sell, holders of NSOs have to pay taxes both when they buy and sell their stocks. They may also have to pay a higher tax rate on their profits, depending on when the stocks are sold.
Restricted stock units (RSUs)Restricted stock units are shares that you can grant to employees over time through a vesting schedule. Employees receive the promise of company equity in the future but can’t exercise their shares until their vesting period ends. In contrast to stock options, which require employees to purchase company shares, RSUs are granted free of charge to employees as long as the vesting period passes. RSUs don’t have immediate financial value but will once they fully vest. This vesting period could be based on the length of employment or the employee’s performance. After the vesting period is complete, RSUs will represent profits for the employee holding them, as long as the company stock is worth something. As an employer, you might prefer RSUs if you’re a pre-IPO startup or private company and have enough equity shares to allocate to employee compensation. These RSUs don’t cost you anything to distribute, and employees will be more motivated to stay until their stocks fully vest. On the flip side, employees may favor RSUs because they don’t have to pay for these shares. As long as the company’s stock is worth anything at all, employees will make more money.However, if a company never achieves an initial public offering or acquisition, employees’ RSUs never turn into real money. Because RSUs are priced when they vest, you also can’t tell employees how much their RSUs will be worth in the future. For these reasons, some employees and job candidates might not see the value in your company’s RSUs as a form of compensation.
Employee stock purchase plans (ESPPs)Employee stock purchase plans allow you to offer equity compensation to a greater number of employees at a discounted price through an elective program. Here’s how an ESPP works: Employees can choose to contribute part of their paycheck, after taxes, to an ESPP to buy company stocks at a discounted rate. Employee contributions then begin to accumulate until the purchase date — the day that the employer will actually purchase stock on its employees’ behalf, based on the total amount of the employee’s contributions. ESPPs are optional, so you don’t immediately dig into the company’s shares with every new employee hire. They also let you offer stock options to more employees in a simple and accessible way, without guaranteeing shares to all employees as part of their compensation. Because stocks purchased under ESPPs are discounted, employees often turn a profit when they sell. ESPPs also often include a “look back” provision. This means that the plan buys stock at the lowest share price between when the employee signed up for the ESPP and when it was actually purchased. With lookback provisions, employees under ESPPs can receive even steeper discounts at purchase and even greater profits when they sell. However, with these greater gains come greater (and more complicated) taxes. Tax treatment of ESPP stock is based on multiple factors, including:
- How long ESPP stock is held
- The stock’s actual discounted price when purchased
- The stock’s market price on its offering date
- The stock’s market price on the purchase date
What are the benefits of equity compensation?Equity compensation is invaluable in attracting and retaining top talent. By granting your workers a stake in your company, you can motivate them to do their best work and stay with the company longer while also giving them tax-benefited income. Equity compensation also helps the company’s bottom line by allowing the company to offer equity in lieu of cash.
Incentivizes workers to see the company succeedWhen employees share ownership in your company, their goals align with your goals. Employees are more likely to act in the best interests of the company when they’ll receive a cut of the profits. Employees with equity are literally invested in the company’s progress, especially if their stock options are tied to their own performance goals. Employees and contractors receive the opportunity to build their net worth along with the company’s wealth, seeing their shares grow in number and value the longer that they stay. Additionally, remote and international employees who receive equity compensation can feel more connected to the company. When they own part of the company, even far away employees can feel like they’re part of the team.Equity compensation can also improve employee retention, helping you attract and retain top talent no matter where they are in the world. Vesting and holding periods motivate employees to stay with the company longer — or at least until their stocks and stock options fully vest. In the age of remote work, your international and remote employees can choose to work anywhere, but equity shares can ensure they have one more reason to stay with your company.
Frees up the company’s capitalOffering equity compensation as an alternative form of payment frees up cash to use for other initiatives. It allows you to save on large salaries without sacrificing the competitiveness of your total compensation package. Freeing up cash funds is especially important to a cash-poor startup but can still be beneficial to a highly profitable enterprise. Capital is crucial to any company’s growth, and offering equity helps you keep money in the bank and maintain a sustainable cash flow. With less money tied up in employee payroll, you can channel it into other ways to push your company forward. For example, you can use capital freed up by equity compensation to adopt new tools, expand departments, or invest in marketing campaigns.
Grants tax deductionsWhen employees sell their equity shares, they are typically responsible for 15% to 20% of long-term capital gains. This tax rate is usually less than regular income tax, which means that employees can earn more than they would if you just gave them bonuses. That is especially true if employees hold onto their stock for several years as it appreciates, beating inflation. However, employees have to hold onto their equity shares for a certain period of time to take advantage of these tax benefits. Usually, this is at least one year after the purchase date. Otherwise, stockholders have to pay ordinary income tax on their profits if they sell their shares prematurely. They also may need to pay this tax rate on profits earned from their stocks if they’re RSUs, NSOs, or purchased under an ESPP.
How to offer your employees equity compensationNow that you’re familiar with the what and why of equity compensation, what about the how? Follow these four steps on how to offer your employees equity compensation:
1. Decide which equity options you will offerChoose which type of equity compensation you want to offer to employees and contractors. What options do your team members actually want? What options are most beneficial to the company? Survey your employees and seek out input from board members and your company’s C-suite to determine what options best suit everyone’s needs.Stock options can be a great way to section off part of your company’s equity specifically for employees to buy, which tends to work particularly well for public companies. ISOs work great if you have extra capital and want to reward more executives and mid- to high-level employees. Meanwhile, NSOs would be better suited for larger companies that have more entry- to mid-level employees and want to claim tax deductions. NSOs also would be better for companies who want to grant stock options to their contractors. RSUs tend to work well for startups and smaller companies with limited capital for cash compensation that want to encourage employees to stay with them long term. ESPPs will work best if you want to outsource your equity compensation program and not worry about allocating shares to individual employees. This guide covers four common types of equity compensation, but there are many more out there. Do further research to find out which options might work best for you.
2. Create an employee option poolYou can’t offer seats to ten people when there are only five left at the table. If you want to do so, you’ll have to bring additional seats over. Similarly, you’ll have to either find existing shares or create new shares to issue to employees. Treat your equity pool like a budget, assigning equity as needed and leaving some room for new investors and future hires. The size of your employee option pool will depend on a variety of factors, including how many shares are already held and how many shares you’ll need to issue in the next few years. If you’re an early-stage startup, your equity pool might be much bigger, with a lot of shares available for both investors and early employees to claim. In contrast, there might not be as much equity available for new hires if the company has been around a while and has a lot of shareholders. Another factor that might influence the number of shares in your equity pool is the number of positions you need to fill and how senior those roles are. If you’re looking to hire for high-level, C-suite positions soon, you’ll likely need to offer a decent amount of equity to attract top talent for those jobs. The size of your option pool should ultimately be decided by your company’s board members and founders. It’s an important business decision for the company as a whole. Whenever new shares are issued, each stockholder suddenly owns a smaller percentage of the company. This also affects the share price and the overall value of the company.
3. Allocate equity based on seniority and market salary ratesHow much equity you offer employees should be based on how much they deserve to earn. After all, equity compensation is part of competitive compensation, and figuring out how to be competitive depends on what your employees are worth. This means that the amount of equity each employee should receive should be based on their level and their market salary rate. Divide employees into different groups based on their tenure and level within your company to determine the distribution of equity. You may decide to offer a greater number of shares to senior employees, top-performers, or executives.
4. Establish a vesting schedule and termsDetermine how long the vesting period will be for each type of equity compensation you offer employees. Define any terms that will impact how and when employees can exercise and sell shares, and make sure to document these in your employment contracts. Include all of the information employees need to know: how many stocks are available to the employee or contractors, what kind of equity, and how long it will take to vest. For startups, the standard vesting schedule for equity awards is usually four years, with a one-year cliff. This means that an employee needs to work at least one year before earning any shares or exercising stock options. They also must remain at the company for four years before all of their stocks are fully vested. If they leave before this four-year period is over, the employee can only keep a percentage of their stock, and only if they’ve left after the 12-month mark. For example, if an employee left after two years, they would only receive 50% of their promised equity. But, if they left before one year, they wouldn’t be able to receive any stock. The four-year vesting period with a one-year cliff doesn’t work for every company. You may establish a shorter vesting period to attract talent faster or set a longer one if you want to increase employee retention. The further down the road you’re looking, the longer your vesting schedule should be.
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The information contained in this site is provided for informational purposes only, and should not be construed as legal advice on any subject matter.
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