Key Points

• Cash equity compensation programs are a type of equity compensation that offer employees cash payments based on the value of the company’s stock or other equity instruments.
• Cash equity compensation programs can take different forms, including cash-settled stock appreciation rights (SARs), cash bonuses tied to equity performance, and other types of cash-based equity awards.
• Cash equity compensation programs have different tax implications than those of traditional equity compensation, with the cash payments generally subject to ordinary income tax and payroll taxes.
• Companies may offer cash equity compensation programs as a way to provide liquidity to employees, retain key talent, and incentivize employees to help drive the company’s growth.
• Employees who receive cash equity compensation should carefully evaluate the terms and conditions of their awards, including any vesting schedules or performance requirements, as well as the tax implications of the awards.

Introduction

For companies looking to incentivize employee performance and loyalty, it’s important to understand how share-based compensation can help. Through cash and equity compensation programs, companies are able to offer their employees rewards that are both meaningful and beneficial. But what exactly is a share-based compensation program? How do they work? What do they entail? In this blog post, we will explore the basics of cash and equity compensation programs, so you can effectively implement them into your company. Read on to learn more about everything you need to know about share-based compensation!

What are cash and equity compensation?

Cash compensation is the amount of money paid to an employee in exchange for their work. This can include wages, salaries, bonuses, and commissions. Equity compensation is a form of payment that gives employees an ownership stake in the company. This is pretty straightforward as cash payment is something we’re all familiar with.

Equity compensation can be a great way to attract and retain top talent, but it’s important to understand the risks involved. Paying employees with equity involves providing them shares of equity in exchange for their work to supplement cash compensation or providing them with stock option plans which, depending on specific situations may make more sense.

This might include providing your employee equity awards for hitting performance goals or an equity offer to help retain them more effectively. Equity offers typically are “restricted” meaning your employees aren’t permitted to sell them until they vest and many have a long-term vesting period.

The benefit behind this is, by providing RSUs to your employees with a 4-year cliff vestment period, they’re required to stay at least 4 years lest they lose their stock which in turn provides them a potentially life-changing motivational reason to stay. You may think “I’m losing equity! That doesn’t sound smart.” however, think about the benefit to the shares you do retain by retaining top talent. The shares you do retain will likely grow faster in value and as a result, will be worth more than the combined value of the shares you’re giving up + those you retain had you not retained them. 

Types of Equity Compensation Programs

There are three main types of equity compensation programs: stock options, employee stock purchase plans, and restricted stock.

Stock options give employees the right to purchase a certain number of shares of company stock at a predetermined price within a certain period of time. An employee stock purchase plan provides employees the ability to buy their company stock at a discount. Restricted stock gives employees the right to purchase a certain number of shares of company stock, but these shares are subject to “vesting” restrictions. Vesting means that the employee must remain employed with the company for a certain period of time before they are allowed to exercise their option to purchase the stock.

Incentive stock options (ISOs) and non-qualified stock options (NSOs)

ISOs and NSOs are the two main types of stock options that companies offer to employees as part of a compensation package. ISOs are typically reserved for key employees and executives, while NSOs are oftentimes available to all employees.

The main benefit of ISOs over NSOs is that ISOs have some very significant tax benefits over NSOs. Here’s how they both are taxed. ISOs and NSOs aren’t taxed at the time of grant meaning your employer can give you thousands of stock options tax-free.

Once you exercise your NSOs, you’ll pay ordinary income tax on the difference between the share price and the predetermined purchase price (strike price). Once you sell the stock you attain through this purchase, you may pay long-term or short-term capital gains depending on your holding period. Your grant date doesn’t change this at all.

ISOs are not subject to income tax at the time of exercise like NSOs are, and, if the shares are held for at least one year after exercise and two years after the grant, the gain on sale is taxed at the long-term capital gains rate. NSOs, on the other hand, are subject to income tax at the time of exercise, and the gain on sale is taxed at the higher short-term capital gains rate.

There are a few key differences between ISOs and NSOs:

1. Exercise price: The exercise price for an ISO must be equal to or greater than the fair market value of the underlying stock on the date of grant. For an NSO, there is no such requirement.

2. Holding period: To receive favorable tax treatment, ISOs must be held for at least one year after exercise before being sold. NSOs do not have this requirement.

3. Treatment of dividends: If shares acquired through an ISO are sold before being held for one year, any dividends received during that time period will be taxed as ordinary income. Dividends received on shares acquired through an NSO are taxed as ordinary income regardless of how long the shares have been held.

Restricted stock units (RSU Plans)

When an employer offers restricted stock units (RSUs) as a form of compensation, it is issuing a promise to deliver a specified number of shares of the company’s stock at a future date. Unlike with stock options, you do not have to purchase the shares when they are first offered. However, you may be subject to taxes on the RSUs when they vest, meaning you become entitled to receive the shares.

There are three key terms associated with RSUs that you should be familiar with, including:

Vesting: Vesting refers to the process by which you earn the right to receive the shares of stock that have been promised to you. With RSUs, vesting typically occurs over a period of time (e.g., four years), and it may be cliff-vested (meaning all units vest at once) or graded (meaning units vest in smaller increments over time).

Cliff-vesting: Cliff-vesting means that all units vest at once. For example, if your RSU grant is for 1,000 units that cliff-vest after four years, then you will be entitled to receive 1,000 shares of stock on the four-year anniversary of the grant date.

Graded-vesting: Graded-vesting means that units vest in smaller increments over time. For example, if your RSU grant is for 1,000 units that graded-vest over four years, then you will be

Employee stock purchase plans (ESPPs)

An employee stock purchase plan (ESPP) is a program offered by many companies that allows employees to purchase company stock at a discounted price. The discount is typically between 5-15%, and the shares can be purchased through payroll deductions.

There are two types of ESPPs:

1. Traditional ESPPs – With a traditional ESPP, employees purchase shares at the end of a designated period (usually 6 or 12 months). The shares are then held until the end of a specified holding period, which is often 1-2 years. This type of plan typically has a “look-back” feature, which means that employees will receive the lower of the stock price on the first day of the offering period or on the last day of the offering period.

2. Open market ESPPs – With an open market ESPP, employees can purchase shares on any day during the offering period. The shares are then held for a specified period of time, which is usually 1-2 years. This type of plan does not have a look-back feature.

Employee stock purchase plans can be an excellent way to build equity in a company and benefit from any future growth. However, there are some risks to consider before participating in an ESPP, such as:

1. The stock price could go down – If the stock price goes down after you purchase shares, you will lose money on your investment.

2. You may be subject to taxes – when you sell your ESPP, you may owe either long term capital gains or short term capital gains on the difference between your initial purchase price and your subsequent sale price. Talk to a tax professional if you want help planning for the tax obligation.

What are the benefits of equity compensation?

Incentivizes workers to see the company succeed

Incentives are a key part of any cash or equity compensation program. They provide employees with a reason to see the company succeed, as their success is directly tied to the company’s success. Incentives can be in the form of bonuses, stock options, or other forms of equity.

Bonuses are often used as an incentive for employees to achieve specific goals. For example, a bonus may be given for meeting sales targets or for completing a project on time and under budget. Bonuses can be paid in cash or shares of stock.

Stock options are another popular form of equity-based incentive. Stock options give employees the right to purchase shares of the company’s stock at a set price (the strike price). If the stock price rises above the strike price, the employee can exercise their option and buy the shares at the lower price, resulting in a profit. Options can be an effective way to incentivize employees to help grow the company, as they stand to benefit financially from the company’s success.

Equity-based incentives can be an effective way to align employee interests with those of shareholders. By giving employees a financial stake in the company’s success, you can motivate them to work hard to help achieve goals that benefit everyone involved.

Frees up the company’s capital

One of the benefits of cash and equity compensation programs is that they can free up a company’s capital. This is because the compensation is paid out over time, rather than all at once. This can help a company to conserve its cash and use it for other purposes. Equity compensation can also help to align the interests of employees with those of shareholders. This is because employees will have a financial stake in the company’s success and will be motivated to work hard to make it successful.

Grants tax deductions

Grants tax deductions can have a big impact on your company’s bottom line. By offering grants to employees as part of their compensation, you can reduce your company’s taxable income and increase your deductions. Grants are also a great way to attract and retain top talent. When used correctly, they can be a powerful tool for building a strong team.

There are two types of grants: restricted and unrestricted. Restricted grants are subject to specific conditions, such as being used for a specific purpose or being earned over a certain period of time. Unrestricted grants can be used for any purpose and don’t have any strings attached.

To qualify for a tax deduction, the grant must be made by the employer and cannot exceed $5,000 per year per employee. The grant must also be made with the intention of providing financial assistance to the employee, not as a gift or reward for services rendered.

If you’re considering offering grants as part of your compensation package, consult with an experienced tax advisor to ensure that you comply with all IRS regulations.

How to offer your employees equity compensation

If you’re like most startups, you’re always looking for ways to attract and retain the best talent. Equity compensation is a great way to do this, but it can be confusing to know how to set up an equity compensation program that works for your company.

Here are some things to consider when offering equity compensation to your employees:

1. Decide which equity options you will offer

There are two types of equity compensation that companies can offer to employees: stock options and restricted stock.

Stock options give employees the right to purchase shares of the company’s stock at a set price, known as the strike price. The strike price is usually set at the market price of the stock on the date the option is granted. The employee can then exercise the option to purchase shares at any time up until the expiration date of the option.

Restricted stock is actual shares of the company’s stock that are granted to an employee. The number of shares and the grant price are set at the time of grant. Unlike stock options, there is no expiration date for restricted stock. However, the shares are typically subject to a vesting schedule, meaning that the employee must stay with the company for a certain amount of time before they own the shares outright.

Both types of equity compensation can be powerful tools to attract and retain top talent. When deciding which type of equity to offer, companies should consider their financial goals and objectives, as well as what will work best for their employees.

2. Create an employee option pool

An employee option pool is a designated percentage of a company’s total shares that are set aside for employees. The pool is typically created at the time of a company’s initial public offering (IPO) or when new rounds of funding are raised.

The purpose of an employee option pool is to attract and retain talented employees. By offering stock options, employees are given an ownership stake in the company, which aligns their interests with those of shareholders.

Stock options give employees the right to purchase shares of the company’s stock at a set price (known as the strike price). The strike price is typically the market price of the stock at the time the options are granted. If the market price of the stock increases above the strike price, employees can exercise their options and buy shares at the lower strike price. This difference between the strike price and market price is known as the “spread.”

Options typically vest over a four-year period, which means that employees must remain with the company for four years before they can exercise their options. Vesting schedules can be cliff-vested or graded. With cliff vesting, all options vest on the same date after four years. With graded vesting, a portion of options vest each year over four years. For example, 25% of options may vest after one year, 50% after two years, and so on.

If an employee leaves the company before their options vest, they lose their options.

3. Allocate equity based on seniority and market salary rates

As with any type of compensation, there are pros and cons to allocating equity based on seniority and market salary rates. On the one hand, this approach can help ensure that employees are fairly compensated for their years of service and experience. On the other hand, it can create a situation where newer, more junior employees feel like they are being unfairly treated.

When deciding whether or not to allocate equity based on seniority and market salary rates, it is important to weigh the pros and cons carefully. If you decide to go ahead with this approach, make sure to communicate your decision clearly to all employees so that everyone is on the same page.

4. Establish a vesting schedule and terms

A vesting schedule is an outline of when an employee will gain full ownership of their equity compensation. The most common vesting schedules are monthly or yearly, although there are other options as well. Vesting can also be cliff-based, meaning the employee only receives the full amount of shares after a certain period of time (usually three to five years).

The terms of an equity compensation plan should be clearly laid out in the initial agreement. This includes how long the vesting period is, what type of vesting schedule will be used, and what happens to the equity if the employee leaves the company before they are fully vested.

Conclusion

Cash and equity compensation programs offer both employers and employees a variety of benefits. Employers can use these programs to attract and retain talented people, while employees can benefit from the potential upside of stock options or restricted shares. However, as with any type of remuneration strategy, there are pitfalls to consider when designing cash and equity compensation plans. It is important for employers to understand the process in order to create an effective plan that will meet their goals as well as those of their team members.