Equity compensation has been a popular non cash pay structure in the tech industry for decades and for good reason. Offering equity compensation is a great way for most companies to attract and retain top talent, while also incentivizing employees to work hard and help the company succeed.
In this article, we will discuss the history and trends of equity compensation in tech, the different types of equity compensation, its benefits for employees, taxation, and why equity compensation works as the best incentive for small and large tech companies apart from cash compensation.
History of Equity Compensation in Tech
Equity compensation, also known as stock compensation, has been a popular way for tech companies to attract and retain top talent since the early days of Silicon Valley. In the 1970s and 1980s, large tech companies like Intel and Apple offered stock options to their employees as a way to incentivize them to work harder and stay with the company for longer periods of time.
During the dot-com boom of the 1990s, equity compensation became even more prevalent in the tech industry. Many early-stage tech companies funded by venture capital that were not yet profitable offered stock options to their employees as a way to compensate them for their hard work and to help them share in the potential future success of the company. This was seen as a way for employees to become "owners" of the company and to have a personal stake in its success, unlike when simply offered cash compensation.
The popularity of how equity compensation works continued to grow in the 2000s and 2010s, as large tech companies like Google, Facebook, and Amazon became some of the largest and most valuable companies in the world. These companies used stock options, RSUs, and other forms of equity compensation to attract and retain top talent, and to give their employees a direct stake in the company's success.
Today, equity pay is a standard part of many tech companies' stock compensation packages, especially at the executive and senior management levels. It continues to be a powerful tool for attracting and retaining top talent, and for aligning the interests of employees with the long-term success of the company.
Types of Equity Compensation
There are several types of equity compensation that are commonly used in the tech industry. The most common types include Stock Options, Restricted Stock Units (RSUs), Stock Grants, and Employee Stock Purchase Plans (ESPPs). Here’s a brief explanation of each, as well as the derivatives of these equity compensation types:
1. Stock Options
Stock options are contracts that give the holder the right to buy a certain number of shares of company stock at a specified price, known as the exercise price or strike price. There are two main types of stock options: Incentive Stock Options (ISOs) and Non Qualified Stock Options (NQSOs).
Incentive Stock Options (ISOs) are typically offered to executives and other high-level employees and offer certain tax advantages, while Non Qualified Stock Options (NQSOs) are more commonly used and are available to a broader range of employees.
2. Restricted Stock Units (RSUs)
Restricted Stock Units RSUs are grants of company equity that are subject to a vesting schedule, typically over a vesting period of several years. Unlike stock options, RSUs represent actual shares of the company’s stock, but the employee does not own them until they have vested.
3. Employee Stock Purchase Plans (ESPPs)
Employee Stock Purchase Plans (ESPPs) are plans that allow employees to purchase the company’s equity at a discounted price, typically through regular payroll deductions. ESPPs can provide a way for employees to acquire the company’s stock at a lower cost than buying it on the open market.
4. Restricted Stock Awards (RSAs)
Restricted Stock Awards (RSAs) are similar to Restricted Stock Units RSUs, but instead of a vesting schedule, they are subject to restrictions on when they can be sold or transferred. For example, an RSA may not be able to be sold until a certain vesting period has elapsed, or until the company reaches certain company performance targets.
5. Stock Appreciation Rights (SARs)
SARs are contracts that entitle the holder to receive the appreciation in the value of a certain number of shares of company equity over a specified period of time. SARs can be a way to provide employees with an incentive tied to the company valuation and performance, without actually granting them percentage ownership of company equity.
6. Performance Shares
Performance shares are grants of company equity that are contingent on the achievement of certain company performance targets, such as meeting revenue or profitability goals. If the company performance targets are met, the employee will receive the shares of stock.
7. Phantom Stock Units
Phantom stock units are similar to SARs, but instead of being based on actual shares of company equity, they are based on the hypothetical value of a certain number of shares. Like SARs, they can be a way to provide employees with an incentive tied to the company's performance.
8. Employee Stock Option Plans
Employee stock option plans are plans that provide employees with the opportunity to purchase company shares at a discounted price, typically through the use of stock options. These plans can provide a way for employees to acquire company shares at a lower cost than buying them on the open market.
9. Stock Bonus Plans
Stock bonus plans are plans that provide employees with grants of company shares as a form of bonus stock compensation. Unlike stock options or RSUs, employees receive the shares of stock immediately, without being subject to a vesting schedule.
10. Stock Purchase Plans
Stock purchase plans are plans that allow employees to purchase company stock directly, typically through regular payroll deductions. These plans can provide a way for employees to acquire company stock at a lower cost than buying it on the open market.
Benefits of Equity-based Employee Compensation
Equity compensation offers many benefits for employees. Perhaps the biggest benefit is the potential for a significant financial windfall if the company's stock price rises over time. This can be especially lucrative for early employees of high growth companies, who may receive tens of millions in dollar value for equity compensation if the private company goes public or is acquired.
Another benefit of startup equity compensation is that it aligns the interests of employees with those of the company's existing shareholders. This can help to motivate employees to work hard and contribute to the company's success, which in turn can lead to a higher stock price and larger returns for everyone involved.
Understanding Vesting Basics
Equity compensation awards typically come with a vesting schedule that outlines when and how much of the award will become available for purchase or sale. As a tech employer, it is necessary to discuss this part of equity compensation with the employees. Here are some important concepts to understand when it comes to equity compensation vesting:
The stock price of a private company is the current market price of a share of its stock. It can be volatile and can fluctuate based on market conditions and other factors. However, the stock price is not the same as the strike price or the fair market value used for equity compensation purposes.
Vesting conditions are the requirements that an employee must meet in order to receive and retain percentage ownership of the startup equity compensation award. The most common type of vesting condition is the time-based vesting schedule, where a certain percentage of the award becomes available over a set vesting period. Performance-based vesting may also be used, where the employee must meet certain goals or milestones to receive the award.
Fair Market Value
Fair market value (FMV) is the stock value or the value of an asset, such as a security, determined by the market demand for the asset. The FMV is often used to set the vesting price for Restricted Stock Units RSUs or the exercise price for stock options. The vesting price must be at or above the FMV on the date of grant to avoid any legal issues.
The strike price is the price at which an employee can purchase stock in a private company through a stock option or other form of equity compensation. The strike price is typically set at or below the FMV of the company's stock at the time of grant to provide an incentive for employees to work hard and contribute to the company's growth.
Taxation of Equity Compensation
The taxation of equity compensation can be complex and depends on several factors, including the type of equity plan, the FMV of the stock, and the employee's tax bracket.
In equity compensation, capital gains tax is the tax that employees pay on the gains they make when they start selling stock that they received through equity grants or other forms of equity pay. For example, when an employee exercises their stock options and sells the shares at a higher price than the strike price, the difference between the FMV of the stock at the time of exercise and the strike price is considered a capital gain. The capital gain is then subject to capital gains tax.
Capital gains tax rates can vary depending on how long the employee held the stock. If the employee held the stock for more than a year, it is considered a long-term capital gain and is subject to a lower tax rate. On the other hand, if the employee held the stock for less than a year, it is considered a short-term capital gain and is subject to the employee's ordinary income tax rate.
For a publicly traded company, the tax treatment of equity compensation is generally more straightforward than it is for private companies. When employees exercise their stock options or receive shares of stock through other equity pay programs, they are typically subject to capital gains tax on the difference between the FMV of the stock at the time of exercise or vesting and the purchase price or strike price at the stock market. This tax liability is incurred at the time the shares are sold or otherwise disposed of. In a publicly traded company, the market price of the stock is readily available and is usually the FMV.
On the other hand, in private companies, employees typically pay capital gains tax on the difference between the FMV of the stock at the time of exercise and the strike price. However, because private companies are unlike the publicly traded company, it can be difficult for employees to determine the FMV of the stock. As a result, private companies may hire independent appraisers to determine the fair market value of their stock.
For RSUs and stock grants, employees will generally pay ordinary income tax on the FMV of the stock when it vests.
Why Equity Compensation is Best for Tech Industry
Equity compensation is particularly well-suited for tech companies for several reasons. First, it allows early stage companies to conserve cash while still attracting top talent. Instead of offering large cash salaries, these private companies can offer equity compensation that may be worth more in the long run.
Second, equity compensation helps to align the interests of employees with those of the company's existing shareholders, which can be especially important in high-growth industries where the stock price can rise rapidly.
Finally, equity compensation can be a great way for employees to build personal finance portfolios and achieve financial independence. By owning stock in the early stage companies they work for, employees have the potential to benefit from the future value of the stock as the company grows and succeeds, which can be particularly valuable in the tech industry where tech companies often experience rapid growth and innovation that increases company valuation.
In addition to these benefits, equity compensation can also help larger tech companies retain talent. By offering equity grants and stock options, these private and public companies can provide additional incentives for employees to stay with the company and work towards long-term goals.
However, it's important to note that equity compensation is not without its drawbacks. For example, the stock value can be volatile and unpredictable, which can lead to significant fluctuations in the value of an employee's compensation package. Additionally, there may be contribution limits or restrictions on when and how employees can sell stock, which can limit their ability to liquidate their investment.
Tax and Investment Advising
Offering equity compensation packages to employees can be a valuable tool for tech companies and startups looking to attract and retain talent. However, it's important for employers to provide employees with the necessary resources to manage the complex tax implications and investment strategies associated with equity compensation.
One way that employers can support their employees is by offering access to tax advice and investment advisory services. This can help employees make informed decisions about their equity compensation packages, reduce how much they pay taxes, and maximize returns. By partnering with trusted a financial advisor and a tax professional, employers can demonstrate their commitment to supporting their employees and fostering a culture of financial literacy and responsibility.
Employers in tech companies and startups should also seek legal expertise when offering equity compensation packages to their employees. Working with a law firm that specializes in equity compensation can help ensure that the terms and conditions of equity grants, stock options, and other forms of equity compensation are fair, transparent, and legally compliant.
A law firm can also help employers navigate the complex legal requirements associated with equity compensation, such as ensuring compliance with securities laws, drafting legal documents, and managing the vesting schedule. By partnering with a trusted lawyer, employers can protect themselves and their employees from potential legal issues and demonstrate their commitment to ethical and transparent business practices.
Overall, employers in tech startups and bigger companies can support their employees and foster a culture of financial literacy and responsibility by providing access to tax advice, investment advisory services, and legal expertise when offering equity compensation packages. By partnering with trusted professionals, employers can help employees make informed decisions, reduce how much they pay taxes, and maximize returns, while also protecting themselves and their employees from potential legal issues.
Equity Compensation Trends in Tech
Equity compensation has become increasingly popular in the tech industry in recent years, with many tech companies offering it as a standard part of their compensation packages. According to a report by the National Center for Employee Ownership, the number of employees receiving equity compensation has significantly increased since the late 1990s.
One of the reasons for this trend is the competitive nature of the tech industry, where early stage companies are constantly vying for top talent. Equity compensation can be a powerful recruiting tool, especially for startups and smaller, earlier stage companies that may not be able to offer the same level of salary as larger companies and more established private companies.
Another trend in equity compensation is the move towards RSUs as a preferred form of equity compensation over stock options. RSUs have become more popular because they are easier to understand and provide employees with a guaranteed payout, as opposed to the potential profit that comes with stock options.
Finally, there has been a growing trend towards greater transparency and simplicity in equity compensation plans. Many public companies and earlier stage companies are moving towards simpler equity compensation plans that are easier for employees to understand, with clear and concise language and fewer complex terms and conditions.
Equity Compensation Management At Your Fingertips
Equity compensation is a valuable tool for small and large tech companies looking to attract and retain talent, while also incentivizing employees to work hard and help the company succeed. By offering equity compensation, private and public companies can align the interests of employees with those of the company's existing shareholders, providing a win-win situation for everyone involved.
However, it's important for employees to seek out tax advice, investment advisory services, and legal expertise to ensure they fully understand the tax implications and other details of their equity compensation packages.
If you’re aiming to revolutionize your employee compensation packages in the same fashion as a hard-hitting tech company in Silicon Valley, you don’t need to look further. Here at Upstock, we help tech startups to in managing the equity grants of their early employees and key talents in a way that’s cost-effective and allows for transparency. Send us a message to know more or talk directly with our expert representative now!