What is equity compensation? (explanation, example, types)

What is equity compensation?

Equity compensation is a non-cash payment where employees receive ownership in the company as part of their compensation package. Employees get shares or the right to purchase shares in the company in addition to, or sometimes instead of, a portion of their salary.

For startups, this is a particularly attractive option since it helps manage cash flow while incentivizing employees to work hard and stay with the company long-term. By offering a stake in your company, you can align your team's success with the company's success.

Common forms of equity compensation include stock options, restricted stock units, and performance shares.

Who gives out equity compensation?

Typically, startups and fast-growing companies are the primary providers of equity compensation. It's common in tech firms, but any business looking to attract top talent, save cash, or motivate employees to help the company grow can use this strategy.

Public companies also offer equity compensation, especially to senior leadership or employees with specialized skill sets, in order to keep them invested in the company's long-term success.

Who should expect to receive equity compensation?

The following people can expect to receive equity compensation: 

• Employees at startups and growing companies.
• Senior executives and top managers.
• Key contributors and top performers.
• Sometimes all employees in the company.

The decision on who gets equity often depends on the size and growth stage of the company, industry norms, company policies, location, and the company’s goals for using equity.

Equity vs. cash compensation

Cash compensation is simple: employees get a fixed salary and bonuses in cash. Equity compensation, on the other hand, gives employees ownership in your company through stock options or restricted stock units.

While cash offers employees immediate value and certainty, equity provides long-term rewards if your company grows successfully.

Cash is easy to understand and manage, but it doesn’t align employee interests with company success as effectively as equity does.

Many companies, especially startups, use a combination of both. They offer competitive but below-market cash salaries along with equity compensation to attract and retain talent.

How does equity compensation work?

Equity compensation involves several key steps. Let’s break down how it typically works:

Option grant

An option grant gives employees the right to buy a specific number of shares in your company at a set price in the future. Important details include:

• The number of shares the employee can buy.
• The price they'll pay (exercise price or strike price).
• When they can buy the shares (vesting schedule).
• How long the offer lasts.

Note: Offering an option grant doesn’t mean the employee owns the shares right away, it just means they are given the right to buy shares in the future at the specified price.

Vesting

Vesting is how you give out your company ownership to employees over time rather than all at once. 

Here's how it works: You offer employees a set number of shares, given gradually (typically over four years with a one-year cliff) or when specific performance goals are met. The employee should stay with your company to receive all the shares. If they leave early, they only keep the shares they've earned.

Vesting helps motivate employees to stay longer and contribute to your business growth.

Exercising

Exercising is when an employee decides to purchase the shares granted to them. They pay the agreed exercise price, turning options into actual ownership. Exercising usually happens when the vesting requirements are met or when the employee believes the company’s value will increase.

Employees usually exercise when:

• Their vesting requirements are met.
• They want to lock in a lower share price.
• When they believe the company's value will increase significantly.
• For potential tax benefits, especially with early exercise.
• They're leaving the company and want to use their options before they expire.

Exercising is a key moment when your employees can start to benefit financially from your company's growth.

Taxes on equity compensation

The government takes its share when employees benefit from their ownership stake in your company. There are typically two main types of taxes involved:

• Income tax: Applied when equity is vested or exercised, based on the fair market value.
• Capital gains tax: Applied when the shares are sold, based on the profit made from the sale.

Taxes on equity compensation can be triggered at various points: vesting, exercising, or selling. The timing of these events can significantly impact the amount of tax owed. Also, different types of equity have different tax implications. 

Note: Employees should consult with a tax professional to understand their specific tax rates.

Types of equity compensation

Stock options

Stock options give employees the right to buy company shares at a predetermined price (exercise price) within a specific timeframe. They're a popular form of equity compensation, especially in startups. 

Typically, options vest over time, encouraging employee retention. There are two main types: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). 

When the market price exceeds the exercise price, employees can profit by exercising their options and selling the shares. 

However, if the stock price falls below the exercise price, options may become worthless (underwater). 

Stock options can offer significant upside potential but also come with risks and complex tax implications.

Non-qualified stock options (NSOs)

NSOs are a common type of stock option that doesn't receive special tax treatment. 

They are more flexible than Incentive Stock Options (ISOs) and can be offered to employees, contractors, and sometimes even board members.

When exercised, NSOs are taxed as ordinary income on the difference between the exercise price and the fair market value at the time of exercise. Companies can deduct this amount as a compensation expense. 

If an employee holds onto the shares after exercising and they increase in value, the employee will have to pay capital gains tax.

NSOs usually allow a longer period of time to exercise options after leaving the company compared to ISOs, giving employees more flexibility. However, they don't have the potential tax advantages that ISOs offer.

Incentive stock options (ISOs)

ISOs are a type of stock option that can offer tax benefits to employees. Unlike NSOs, ISOs are only available to employees. They're designed to encourage long-term investment in the company.

When exercised, ISOs don't trigger immediate ordinary income tax. If the employee holds the shares for at least one year after exercise and two years from the grant date, any profit is taxed as long-term capital gains, which typically have lower rates than ordinary income tax.

However, ISOs, when exercised, can trigger alternative minimum tax (AMT)—a separate tax calculation designed for high-income earners so they pay a minimum level of tax. 

Also, ISOs allow only 90 days to exercise options after leaving the company, which is shorter than NSOs.

Restricted stock units (RSUs)

With RSUs, employees receive company stock over time. Unlike stock options, RSUs promise actual stock ownership, not just the right to buy stock.

RSUs typically follow a vesting schedule, often over several years. Once vested, the shares are given to the employee and are taxed as ordinary income based on their fair market value at that time.

RSUs offer more certainty than stock options because they always have value as long as the company's stock has value. 

They're becoming increasingly popular, especially in established companies, as they're easier to understand and less risky for employees.

Performance shares

Performance shares are a type of equity-based compensation linked to specific company or individual goals. These include: 

• Financial targets (e.g., earnings per share, revenue growth)
• Operational goals
• Total shareholder return
• Market share
• Strategic objectives

Employees get shares only if these goals are met within a set time. This ties compensation directly to the company's success.

Performance shares can be more motivating than traditional stock options or RSUs because they reward exceptional performance. However, they also carry a higher risk for employees, as underperformance may result in no payout.

Generally, performance shares are not taxed at grant. However, ordinary income tax is applied upon vesting, and additional capital gains if shares are held after vesting.

Companies often give performance shares to executives and key employees to drive strategic goals and foster a results-focused culture.

Stock appreciation rights (SARs)

SARs give employees the right to receive the appreciation in value of a specified number of company shares over a set period without actually owning the shares.

When exercised, employees receive the difference between the stock's current market price and the grant price, either in cash or in shares. This means they don't need to pay to exercise options.

Types of SARs include: 

• Cash-settled: Employee receives the appreciation in cash.
• Stock-settled: Employee receives shares equal to the appreciation value.
• Tandem SARs: Issued with stock options to help fund option exercises.

SARs are often easier to manage than regular stock options and can be less dilutive for current shareholders. They're taxed as regular income when exercised, making taxes simple for employees.

Phantom stock

Phantom stock, also called shadow stock or ghost shares, mimics stock ownership without giving actual shares. It offers employees the financial benefits of owning stock without diluting existing shareholders' equity.

Phantom stock plans promise a cash payment equal to the value of a certain number of shares at a future date, including any increase in stock price and possibly dividends.

Types of Phantom Stock plans include:

• Full-value plans: Pay the full value of the stock at the time of settlement.
• Appreciation-only plans: Pay only the increase in stock value since the grant date.

Phantom Stock is particularly useful for private companies or those wanting to limit actual share distribution.

It is usually taxed as regular income when paid out, and companies can deduct it as a compensation expense.

It should comply with deferred compensation rules like Section 409A in the US and may need complex valuation for private companies.

Employee stock purchase plans (ESPPs)

ESPPs allow employees to buy company stock at a discounted price, typically through payroll deductions. These plans offer a way for employees to invest in their company and potentially benefit from its growth.

ESPPs usually have an offering period during which employees can accumulate funds, followed by a purchase date when shares are bought. 

The discount is often 10-15% off the market price, sometimes applied to the lower of the price at the beginning or end of the offering period.

ESPPs can be a great benefit for employees, providing an easy return on investment. They're also simple to manage and can increase employee engagement and loyalty.

Apart from these equity compensation types, other forms of startup financing, such as SAFE notes, can also impact a company's equity structure, though they're not typically used for employee compensation.

Benefits of equity compensation

• Attracts top talent: By offering equity compensation, you can compete with big companies for skilled employees, even if you can’t match their cash salaries.
• Increases retention: Vesting schedules encourage employees to stay longer with your company. This reduces churn and maintains team cohesion.
• Aligns interests: When employees become shareholders, they are more invested in your company’s success. This can lead to increased motivation, productivity, and innovation.
• Saves money: You can reduce upfront salary costs by offering compensation with equity. This helps you save money for other critical business needs.
• Builds loyalty: If your company grows successfully, equity can provide substantial financial benefits to employees. This can create a sense of loyalty, further strengthening your team.

Challenges of equity compensation

• Dilution of ownership: As you grant more equity to employees, existing shareholders' ownership stakes reduce. This can be a sensitive issue, particularly for founders and early investors who may see their control and potential returns diminish.
• Market volatility: The value of equity can fluctuate. This can cause anxiety among employees and potentially impact retention if your stock price drops substantially.
• Valuation issues: For private companies, determining the fair market value of shares can be difficult. This can lead to tax issues and potential disputes with employees or investors.
• Administrative Burden: Managing equity compensation requires ongoing attention and resources. You'll need to track vesting schedules, handle exercises, and maintain accurate records.
• Legal and Regulatory Compliance: You'll need to handle complex legal and tax regulations. Failure to comply can result in severe penalties and legal complications.

What is a typical amount of equity compensation?

While there is no specific figure, industry data provides some helpful benchmarks for equity compensation.

On average, startups set aside 13% to 20% of their equity for employee compensation. Within this employee equity pool, the distribution typically varies by seniority level:

• C-suite executives: 0.8% to 5%
• Vice president: 0.3% to 2%
• Director: 0.4% to 1%
• Independent board members: 1%
• Managers: 0.2% to 0.33%
• Junior-level employees and other hires: 0% to 0.2%

Equity compensation example

Let’s say a startup is offering a new employee an equity package as part of their compensation. The employee receives stock options for 10,000 shares at an exercise price of $1 per share. The company sets a four-year vesting schedule with a one-year cliff.

• Year 1: After the first year, 25% of the options (2,500 shares) vest. The employee can now purchase these shares at $1 each.

• Years 2-4: The remaining options vest monthly over the next three years. By the end of year four, all 10,000 options are vested.

Now, if the employee exercises all their vested options and immediately sells the shares, they would make a total profit of $40,000. Here’s the breakdown:

Profit per share = Current market price - Exercise price = $5 - $1 = $4

Total profit = Profit per share × Number of vested shares = $4 × 10,000 = $40,000

This example shows how equity compensation can provide significant financial rewards if the company performs well.

FAQs about equity compensation

What is an example of equity compensation?

A common example is stock options. An employee might receive the right to purchase 1,000 shares of company stock at $10 per share after a vesting period. If the stock price goes up to $15, the employee can buy the shares at $10 and possibly sell them at $15, making a profit of $5 per share.

Does equity compensation count as income?

Yes, equity compensation typically counts as income for tax purposes. The timing and amount of taxable income depend on the type of equity and when it's granted, vested, exercised, or sold. For instance, with non-qualified stock options, you're taxed when you exercise the options.

What is the most commonly used form of equity compensation?

Stock options are the most common form of equity compensation, especially in startups and fast-growing companies. They give employees the right to buy company stock at a predetermined price within a specific timeframe. RSUs are also becoming increasingly popular, particularly in more established companies.

What is the risk of equity compensation?

The main risk is that the company's value might drop, making the equity less valuable or even worthless. There's also a risk of dilution if more shares are issued. Additionally, for private companies, there might be limited opportunities to sell shares.

How do you negotiate equity compensation?

To negotiate equity compensation, research industry standards for your role and the company's stage. Understand the company's valuation and growth potential. Ask about the type of equity, vesting schedule, and any restrictions. Don't hesitate to ask for clarification on complex terms.

Is equity compensation the same as profit sharing?

No, they are different. Equity compensation gives employees ownership in the company through stock or stock options. Profit sharing gives employees a share of the company's profits. Equity can increase in value over time, while profit sharing is typically a more immediate benefit.

Why do companies offer equity?

Companies offer equity to align employee interests with company success, attract top talent, and save money. It motivates employees to work towards increasing the company's value. For startups, it's a way to compete with bigger companies' salary offers. Equity also helps retain employees because of vesting schedules.

Conclusion: Streamline your finances with Rho

Equity compensation is an effective method for startups and growing companies to attract and retain top talent while aligning employee interests with business success. 

By understanding different types of equity compensation, their benefits, and potential challenges, you can strategically implement them to motivate your teams and drive growth. 

As you consider equity compensation for your company, Rho can help streamline your business banking needs, providing the tools and insights necessary to manage cash flow, expenses, and investments efficiently. 

With Rho, you can focus on building a successful company while we handle the financial complexities.

Schedule a demo with us today!

Pia Mikhael is a guest contributor. The views expressed are theirs and do not necessarily reflect the views of Rho.

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Note: This content is for informational purposes only. It doesn't necessarily reflect the views of Rho and should not be construed as legal, tax, benefits, financial, accounting, or other advice. If you need specific advice for your business, please consult with an expert, as rules and regulations change regularly.