Equity compensation is a form of non cash pay often used by emerging yet cash poor startups and growing companies for attracting and retaining employees while conserving cash. Equity aligns individuals incentives and employees’ interests with company success, as they become invested in the growth and profitability of the business.
In this Equity Compensation 101 guide, we’ll explore the basics of equity compensation and how it works.
What is an Equity Compensation?
Equity broadly refers to the practice of granting partial ownership in a company to its employees. This can be done through various types of equity compensation programs, such as stock options, Restricted Stock Units (RSUs), Restricted Stock Awards (RSAs), and the Employee Stock Purchase Plan (ESPP). Equity compensation is commonly used in both public companies and private companies, although the specific rules and regulations may vary depending on the company's status.
A Brief History Lesson on Equity Compensation
Granting partial ownership in a company has been proven to be one of the most effective ways to attract and retain talent, creating so much significance companies ranging from small startups to the Fortune 500 have made it their popular choice. This is usually done through equity based compensation.
Equity compensation has a long history, dating back to the early days of capitalism when business owners granted partial ownership to key employees and investors. However, it wasn't until the 20th century that equity compensation programs became more widespread and formalized.
In the 1920s, a number of iconic high-growth companies such as General Electric, General Motors, and IBM started granting stock awards to their high paid executives as a way to align their incentives with those of the company by owning stock. During World War II, the federal government imposed wage and price controls, which made it difficult for private companies to compete for top talent through cash pay. As a result, some companies turned to stock options and other forms of equity compensation to attract and retain talent.
In the 1980s and 1990s, equity compensation became even more popular, as private sector employees sought a share of the significant financial success enjoyed by some high-tech and venture-backed firms. The rise of equity compensation programs coincided with a growing trend to limit executive pay and reduce cash spending on payroll and other operating expenses.
However, equity compensation programs have also been the subject of controversy. In the 1990s, President Bill Clinton attempted to limit executive pay by imposing a $1 million cap on tax-deductible salaries, which led some companies to grant more equity based compensation. More recently, some critics have argued that equity compensation unfairly benefits top executives and may contribute to income inequality. Additionally, there have been concerns about the potential misuse of equity compensation, such as the practice of backdating stock options to pay executives a higher payout.
Despite these controversies and the incident where President Bill Clinton attempted to intervene, equity compensation remains an important tool for companies to attract, retain, and align talent. As companies mature and continue to experience fast growth, they often find that offering equity based compensation is more appealing to many job candidates than high cash compensation alone.
By granting partial ownership in the company, equity compensation aligns individual incentives with company success and can help retain exceptional talent over the long term. For private companies, equity compensation can also help recruit senior employees who may be hesitant to join a cash-poor startup without the promise of future value. Overall, equity compensation is a powerful tool for building a culture of employee ownership and driving company success.
Types of Employee Equity Compensation
Historically, a non cash pay package such as equity broadly refers to a handful of compensation structures meant to help cash poor startups in persuading early employees to take pay cuts while promising an employee ownership shared with the company.
There are several types of equity compensation that companies may grant to their employees:
1. Stock Options
Stock options give employees the right to purchase company stock at a predetermined price, known as the strike price or exercise price. Incentive Stock Options (ISOs) and Non Qualified Stock Options (NQSOs) are the two main types of stock options, each with different tax liabilities. Incentive Stock Options (ISOs) are governed by specific rules under the Internal Revenue Code and may have potential tax advantages, while Non Qualified Stock Options (NQSOs) are more flexible but subject to ordinary income tax upon exercise.
2. Restricted Stock Units (RSUs)
Restricted Stock Units RSUs are promises to grant company stock to public and private sector employees at a future date, subject to vesting requirements. Restricted Stock Units RSUs are typically taxed as ordinary income upon vesting, based on the fair market value of the stock on that date. Restricted Stock Units RSUs are popular in many employee equity compensation programs due to their simplicity and ease of administration.
3. Restricted Stock Awards (RSAs)
Restricted Stock Awards (RSAs) are actual company stock granted upfront, but the shares are subject to vesting and may be forfeited if vesting requirements are not met. RSAs are taxed as ordinary income at the time of grant, based on the fair market value of the stock on that date, unless the employee makes a Section 83(b) election.
4. Employee Stock Purchase Plan (ESPP) a.k.a. Purchase Company Stock
Employee Stock Purchase Plan (ESPP) allows private sector employees to purchase company stock at a discounted price through payroll deductions. Employee Stock Purchase Plan (ESPP) may have favorable tax treatment, but it's important to understand the specific rules of the plan and any holding period requirements.
5. Stock Appreciation Rights (SARs)
SARs are a type of employees equity compensation. SARs are a form of incentive compensation that entitles private sector employees to receive an appreciation in the future value of the company's shares. SARs as a type of incentive compensation are typically granted to employees as a bonus or incentive, and they provide employees with the opportunity to benefit from the increase in the company's stock price without having to purchase the actual stock.
6. Performance Shares
Performance shares are grants of company stock that are contingent upon the achievement of certain performance goals or metrics, such as revenue growth, profitability targets, or other key performance indicators (KPIs). Performance shares are typically granted with a vesting period, and employees may receive the shares or the cash equivalent based on the achievement of the specified performance goals.
7. Phantom Stock Units
Phantom stock is a form of employee equity compensation that provides private sector employees with a virtual percentage ownership in the company's shares without actually granting them actual shares. Phantom stock units are typically tied to the value of the company's stock and may be given as a cash pay or converted into actual shares at a predetermined time or event, such as a change of control or an initial public offering (IPO).
8. Employee Stock Ownership Plans (ESOPs)
ESOPs are retirement plans that invest primarily in company stock and provide early employees and new hires with a percentage ownership stake in the company. ESOPs are typically designed to provide employees with a long-term incentive to help build the company's value and align their interests with those of the company's shareholders.
9. Stock Bonus Plans
Stock bonus plans are similar to ESOPs in that they provide employees with shares of the company's stock as a form of bonus or incentive. However, unlike ESOP stock compensation plans, stock bonus plans may not have the same tax advantages and are typically used for smaller companies or as a one-time grant that allows owning stock.
10. Stock Purchase Plans
Stock purchase plans allow early employees to purchase company stock at a discounted price, often through payroll deductions. These plans can be either qualified or non-qualified under the Internal Revenue Code, with different tax obligations for employees.
Vesting refers to the timeline over which employees equity compensation becomes fully owned by the employee. Vesting schedules vary and can range from immediate vesting to vesting over several years. Vesting is used as a retention tool, as it incentivizes private sector employees to stay with private companies and helps align their interests with long-term company success.
The tax implications of equity compensation can be complex and vary depending on the type of equity compensation and the specific circumstances. Here is a general overview:
For Stock Options
The tax implications of stock options depend on whether they are Incentive Stock Options (ISOs) or Non Qualified Stock Options (NQSOs). ISOs have specific rules under the Internal Revenue Code and may have potential tax advantages, but they also have strict requirements. Non Qualified Stock Options (NQSOs) are more flexible but subject to ordinary income tax upon exercise, based on the difference between the fair market value of the stock at exercise and the exercise price.
- Incentive Stock Options (ISOs)
When Incentive Stock Options (ISOs) are exercised, there are no immediate tax consequences. However, if the stock is held for at least one year from the date of exercise and two years from the date of grant, the difference between the fair market value (FMV) of the stock at the time of exercise and the strike price is taxed as long-term capital gains when the stock is eventually sold. If the holding period is not met, the stock sale may trigger ordinary income tax on the difference between the FMV at exercise and the strike price, and any further gain or loss may be taxed as short-term or long-term capital gains or losses, depending on the holding period.
- Non Qualified Stock Options (NQSOs)
When NQSOs are exercised, the difference between the FMV of the stock at the time of exercise and the strike price is considered ordinary income and subject to ordinary income tax. This ordinary income is typically included in the employee's W-2 for the year of exercise. Any subsequent gain or loss from the sale of the stock is taxed as short-term or long-term capital gains or losses, depending on the holding period.
For Restricted Stock Units (RSUs)
Restricted Stock Units RSUs are typically taxed as ordinary income at the time of vesting based on the FMV of the stock on the vesting date. This ordinary income is typically included in the employee's W-2 for the year of vesting. Once the Restricted Stock Units RSUs are settled and converted into actual shares, any subsequent gain or loss from the sale of the stock is taxed as short-term or long-term capital gains or losses, depending on the holding period.
For Stock Appreciation Rights (SARs)
SARs are typically taxed as ordinary income at the time of exercise or settlement based on the appreciation of the stock’s future value. This ordinary income is subject to paying taxes on ordinary income and may be included in the employee's W-2 for the year of exercise or settlement.
For Performance Shares, Phantom Stock, ESOPs, Stock Bonus Plans, and Company Stock Purchase Plans
The tax implications for these types of employees equity compensation can vary depending on the specific plan design and circumstances. It's important for employees to thoroughly review the plan documents and consult with a tax professional or financial advisor for guidance on the tax implications of these types of equity compensation.
It's crucial to note that tax laws are complex and subject to change, and the tax consequences of equity compensation can vary depending on individual circumstances and the specific provisions of the company's stock compensation plan. It's highly recommended that private sector employees seek the guidance of a qualified tax professional to understand the tax liabilities of their equity compensation and make informed decisions.
Issuing Equity Compensation
Issuing equity compensation involves various steps and considerations. Here is a general overview:
Granting Equity Compensation
Companies grant equity compensation to employees through a formal process that typically involves issuing stock options, Restricted Stock Units RSUs, Restricted Stock Awards (RSAs), or the Employee Stock Purchase Plan (ESPP) through a formal equity plan or program. The equity plan or program will outline the terms and conditions of the equity compensation, including the type of equity, vesting schedule, and any other restrictions or requirements.
Recordkeeping and Compliance
Companies must maintain proper records of equity grants, including the number of shares granted, the grant date, the vesting schedule, and other relevant details. It's also important for companies to comply with applicable laws, regulations, and accounting standards related to equity compensation, such as those under the Internal Revenue Code, the Securities and Exchange Commission (SEC), and the Financial Accounting Standards Board (FASB).
Considerations for Employees
Employees who receive equity compensation on top of their health insurance and high cash compensation should carefully consider their options and understand the potential implications. Here are some key considerations:
1. Financial Planning
Equity compensation can have a significant impact on an employee's financial life, as it can provide the opportunity for significant financial success and make the employees wealthy if the company's shares appreciate in future value. Employees should consider consulting with a financial advisor or tax professional to develop a comprehensive financial plan that includes their equity compensation and takes into account factors such as paying taxes, diversification, and risk management.
2. Tax Planning
The tax liability of equity compensation can be complex, and employees should be aware of the potential obligation of paying taxes associated with their equity awards. It's important to understand the specific tax rules and implications for the type of equity compensation received, as well as any holding period requirements or other tax planning opportunities.
3. Diversification and Risk Management
Holding a significant amount of equity in one company can be risky, as the value of the company's shares can be volatile. Employees should consider diversifying their investments and managing their risk by gradually selling company stock, especially if it represents a significant portion of their overall investment portfolio.
4. Company Performance and Exit Strategies
The value of equity compensation is closely tied to the performance of the company's shares. Employees should stay informed about the company's financial health, company strategies, and market conditions that may impact the stock price. Additionally, employees should consider the potential exit strategies of the company, such as going public, being acquired, or issuing dividends, as these events can significantly impact the value of their equity compensation.
Making Equity Compensation Management Easier and Cost-Effective
Equity compensation is a valuable tool used by public companies and private companies for attracting and retaining employees, as well as incentivizing key talents. It provides employees with a stake in company success, as well as equity aligns individual incentives and their interests with those of the shareholders. Understanding the types of equity compensation, vesting, tax consequences, and other considerations is crucial for both employers and employees.
Employers and hiring managers should carefully design and administer their equity compensation plans, comply with relevant laws and regulations, and communicate clearly with employees about the terms and conditions of their equity awards. Employees should educate themselves about the specifics of their equity compensation, seek professional advice when needed, and make informed decisions about financial planning, tax planning, diversification, and company performance.
It's also important to note that equity compensation can be complex and may require ongoing monitoring and management. Employees should regularly review their equity awards, stay updated on any changes in the company's financial health or stock performance, and reassess their financial and investment strategies accordingly.
Equity Compensation That Ticks The Checklist
We hope that this Equity Compensation 101 guide has helped you understand the basics of equity compensation and its potential benefits for both employers and employees. We tried to make it as comprehensive yet as easy-to-understand as possible so all you have to do is take your pick from the list of equity compensation packages you can offer your key talents.
On the same note, if you consider implementing equity compensation plans for your company, keep in mind that Upstock offers an easy, transparent, and fair platform for granting employees equity. With Upstock, you can simplify the equity compensation onboarding process, manage vesting schedules, customize your plans, and ensure that your team feels empowered to make informed decisions about their equity awards. Learn more beyond our Equity Compensation 101 primer and how Upstock can help you align your team's incentives and build a culture of employee ownership today!