What Is Equity Compensation?
Equity compensation is non-cash pay that is offered to employees. Equity compensation may include options, restricted stock, and performance shares; all of these investment vehicles represent ownership in the firm for a company's employees.
Equity compensation allows the employees of the firm to share in the profits via appreciation and can encourage retention, particularly if there are vesting requirements. At times, equity compensation may accompany a below-market salary.
Key Takeaways
- Equity compensation is non-cash pay that is offered to employees.
- Equity compensation may include options, restricted stock, and performance shares; all of these investment vehicles represent ownership in the firm for a company's employees.
- At times, equity compensation may accompany a below-market salary.
- Equity compensation is a benefit provided by many public companies and some private companies, especially startup companies.
Understanding Equity Compensation
Equity compensation is a benefit provided by many public companies and some private companies, especially startup companies. Recently launched firms may lack the cash or want to invest cash flow into growth initiatives, making equity compensation an option to attract high-quality employees. Traditionally, technology companies in both the start-up phase and more mature companies have used equity compensation to reward employees.
With equity compensation, there is never a guarantee that your equity stake will actually pay off. As opposed to equity (or in combination with equity compensation), beingpaid a salary can be beneficial if you know exactly what you're getting. There are many variables that can impact your equity compensation.
Types of Equity Compensation
Stock Options
Companies that offer equity compensation can give employees stock options that offer the right to purchase shares of the companies' stocks at a predetermined price, also referred to as exercise price. This right may vest with time, allowing employees to gain control of this option after working for the company for a certain period of time. When the option vests, they gain the right to sell or transfer the option. This method encourages employees to stick with the company forthe long term. However, the option typically has an expiration.
Employees who have this option are not considered stockholders and do not share the same rights as shareholders. There are different tax consequences to options that are vested versus those that are not, so employees must look into what tax rules apply to their specific situations.
Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs)
Additional types of equity compensation include non-qualified stock options (NSO) and incentive stock options (ISOs). ISOs are only available to employees (and not non-employee directors or consultants). These options provide special tax advantages. For example, with non-qualified stock options, employers do not have to report when they receive this option or when it becomes exercisable.
Restricted Stock
Restricted stock requires the completion of a vesting period. Vesting may be done all at once after a certain period of time. Alternatively, vesting may be done equally over a set period of years, or any other combination that the management of a company finds suitable. Restricted stock units (RSUs) are similar, but they represent the company's promise to pay shares based on a vesting schedule. This offers some advantages to the company, but employees do not gain any rights of stock ownership, such as voting, until the shares are earned and issued.
Performance Shares
Performance shares are awarded only if certain specified measures are met. These could include metrics, such as an earnings per share (EPS) target, return on equity (ROE), or the total return of the company's stock in relation to an index. Typically, performance periods are over a multi-year time horizon.
FAQs
Equity compensation is a non-cash pay strategy where companies offer employees ownership stakes in the form of company stock. This approach includes various types such as stock options, restricted stock units (RSUs), and employee stock purchase plans (ESPPs).
How does equity compensation work? ›
With an equity compensation plan, employees may be offered shares outright or offered the opportunity to purchase shares at a discounted rate within a designated time window (typically within a certain time of leaving the company).
What are the different types of equity in concern to compensation? ›
Equity compensation is provided in different forms, such as stock options, performance shares, and restricted stock. Employees who receive equity compensation could share the company's profits through appreciation. Several companies, especially startups, use equity compensation.
What is the most common form of equity compensation? ›
A stock option is the most commonly used form of equity compensation. It's a contract that gives the holder the right, but not the obligation, to buy or sell shares of a particular stock at a predetermined price, also known as exercise price, within a specific time frame.
How does equity work in a company? ›
Equity represents the shareholders' stake in the company, identified on a company's balance sheet. The calculation of equity is a company's total assets minus its total liabilities, and it's used in several key financial ratios such as ROE.
Should I accept equity compensation? ›
The major advantage of employee equity compensation is the financial considerations both for the employer and the employee. It allows employers to offer their employees more – which is great for the employees – while not affecting their bottom line – which is great for the employer.
How much equity should I ask for? ›
As a rule of thumb, a non-founder CEO joining an early-stage startup (that has been running less than a year) would receive 7-10% equity. Other C-level execs would receive 1-5% equity that vests over time (usually 4 years).
How do equity holders get paid? ›
Equity owner's payment implies that each quarter the organization will take a fragment of its benefits, split it up and give those benefits to investors as indicated by how much stock somebody has. The more benefit the organization makes, the more cash the investor gets compensated towards at the end of the quarter.
How to pay someone in equity? ›
How is equity paid out? Each company pays out equity differently. The two main types of equity are vested equity and granted stock. With vested equity, payments are made over a predetermined number of installments delineated by a contract.
How is equity calculated? ›
Take your home's value, and then subtract all amounts that are owed on that property. The difference is the amount of equity you have. For example, if you have a property worth $400,000, and the total mortgage balances owed on the property are $200,000, then you have a total of $200,000 in equity.
There's another risk with all forms of equity compensation: Concentration risk. Your financial future already depends on your employer to pay a salary and benefits. Equity compensation makes you even more invested in the financial stability of your employer, which can make you vulnerable if the employer falters.
How much equity should a VP get? ›
For early-stage startups, equity tends to be higher, around 1.5% to 3%, to compensate for higher risk. On the other hand, for more established companies, the range is usually 0.5% to 1.5%. This allocation ensures the VP of Sales is motivated and aligned with the company's long-term goals.
How to give employees equity? ›
There are two common ways to grant Common Stock to employees: through stock options or restricted stock. As an early-stage startup, stock options are by far the most common way to grant equity to employees. However, it's important for you to understand the alternative so you can make the best possible decision.
Is equity better than salary? ›
Potential Financial Upside: Equity can offer the possibility of significant financial gains if the company becomes successful. In those cases, the value of your equity can far exceed the financial benefits of a higher salary. Equity Ownership: By having share options, you become a part owner of the company.
How to structure equity compensation? ›
Follow these four steps on how to offer your employees equity compensation:
- Decide which equity options you will offer. ...
- Create an employee option pool. ...
- Allocate equity based on seniority and market salary rates. ...
- Establish a vesting schedule and terms.
Equity can be defined as the amount of money the owner of an asset would be paid after selling it and any debts associated with the asset were paid off. For example, if you own a home that's worth $200,000 and you have a mortgage of $50,000, the equity in the home would be worth $150,000.
Does equity compensation count as income? ›
Your award pays out Ordinary income and FICA* • Your employer withholds these taxes for you. On your W-2, your employer reports the value of your shares as income, along with the amount of taxes withheld. Use the information on your W-2 to complete your tax return.
Is 1% equity in a startup good? ›
Up to this point, generally speaking, with teams of less than 12 people, the average granted equity for startup employees is 1%. This number can be as high as 2% for the first hires, and in some circ*mstances, the first hire(s) can be considered founders and their equity share could be even greater.
How do you calculate total compensation with equity? ›
Specifically the unknown refers to the equity component, see the two formulas below:
- Total Compensation Public Company = Base + Any Bonuses + RSUs.
- Total Compensation Private Comp = Base + Any Bonuses + Future “Value” of Options.
The most common type of equity compensation, restricted stock units (RSUs), are offered when a company has a stable valuation or goes public. Similar to stock options, they vest over time, but you don't have to buy them. Therefore, RSUs have less risk while enticing employees to stick around for their assets to vest.
