Equity compensation is becoming increasingly popular among companies of all sizes as a way to reward and retain employees. But what does it actually mean, how does it work, and how can you implement an equity compensation plan for your company?
In this article, we’ll explore the fundamentals of equity compensation, from what it is to the different types of plans you can use. We’ll also provide some tips on how to create an equitable equity compensation plan that works for both employers and employees. With this knowledge under your belt, you’ll be ready to start implementing equity compensation in your business.
What is Equity Compensation?
If you’re like most people, the phrase “equity compensation” probably makes you think of stock options. And it’s true that stock options are the most common form of equity compensation. But there are other types of equity compensation as well, such as restricted stock, employee stock purchase plans & phantom stock.
Equity compensation is a way for companies to reward employees (and sometimes directors and consultants) with a stake in the company’s ownership. It aligns the interests of employees with those of shareholders because employees will benefit if the company’s value increases. Equity compensation can also be used to attract and retain top talent.
There are two main types of equity compensation: restricted stock and stock options.
Restricted Stock: Restricted stock is actual shares of the company’s stock that are granted to an employee. The shares vest over time, which means the employee has a right to them after meeting certain conditions, such as completing a certain number of years with the company or reaching certain performance milestones. Once the shares vest, the employee can sell them or hold on to them in hopes that they will increase in value.
Stock Options: A stock option is the right to purchase a certain number of shares of the company’s stock at a set price (the “grant price”) within a certain period of time (the “vesting period”). For example, an employee might be granted stock options when they’re hired as new talent for the company. This would give them the ability to purchase shares of company stock at a predetermined price regardless of the share price that the stock is selling for at that moment in time. They’re only permitted to buy at that preset price during the vesting period (a set amount of time which typically is anywhere from 2-5 years).
Different types of equity compensation
There are many different types of equity compensation that companies can offer to their employees. The most common type is stock options, which give employees the right to purchase shares of the company’s stock at a set price (known as the strike price) over a set period of time. Other types of equity compensation include restricted stock units (RSUs), performance-based stock awards, and employee stock purchase plans (ESPPs).
Stock options are the most popular form of equity compensation, and they can be used to attract and retain top talent. However, they can also be complex and confusing for employees. That’s why it’s important to have a clear and concise equity compensation plan in place before you start offering options to your employees.
Restricted stock units (RSUs) are another popular form of equity compensation. RSUs are similar to stock options in that they give employees the right to purchase shares of the company’s stock at a set price over a set period of time. However, with RSUs, there is no strike price—employees simply receive the shares on a specified date. The vesting schedule is typically based on meeting certain milestones, such as remaining employed with the company for a certain number of years or achieving specific performance goals.
Performance shares are another type of equity compensation that can be used to reward and motivate employees. These awards are given based on the achievement of specific goals, such as increasing sales or hitting personal performance goals.
What’s the difference between ISOs and NSOs and why should I care?
There are two types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). The main difference between them is that ISOs offer certain tax benefits that NSOs do not.
ISOs are only available to employees, while NSOs can be granted to anyone. When you exercise an ISO, you do not have to pay taxes on the difference between the strike price and the fair market value of the stock. With an NSO, you will have to pay ordinary income taxes on the difference between the strike price and the fair market value of the stock.
If you hold your ISO shares for more than one year after exercising them, and you sell them for a profit, you will be taxed at the long-term capital gains rate. With an NSO, you will be taxed at your ordinary income tax rate when you initially exercise them on the difference between your predetermined price and the current market price of the shares.
So, why should you care about the difference between ISOs and NSOs? If you are eligible for ISOs, they can offer significant tax advantages over NSOs. However, there are some risks associated with ISOs that you should be aware of before exercising them. If they give you the option to choose one or the other, it’s important to understand what to expect and know what questions to ask. If you aren’t sure what questions to ask your tax advisor for help understanding the different forms.
What is an ESPP?
An employee stock purchase plan (ESPP) is a benefit offered by many employers that allow employees to purchase company stock at a discounted price. There are two types of ESPPs: with and without a look-back period. A look-back period means that the employee pays the lower of the two prices, either the price on the grant date or the price on the purchase date. Without a look-back period, the employee pays the price on the purchase date.
Employees typically fund their ESPP account through payroll deductions over a period of time, usually 6 to 12 months. Providing employees access to be able to purchase shares of common stock in their employer can give them a sense of ownership and provide them a vested interest in the company’s success which can improve company culture and help small businesses retain their most talented employees.
What are RSUs?
RSUs, or restricted stock units, are a type of equity compensation used by many companies as a way to reward employees. RSUs are given out in addition to, or in lieu of, traditional stock options and can be used to incentivize and retain key employees.
While RSUs have some similarities to stock options, there are also some important differences that you should be aware of. Here’s a quick overview of how RSUs work and how they can be used as part of your employee equity compensation plan.
Unlike stock options, which give you the right to purchase shares at a set price in the future, RSUs are actual shares of stock that are awarded to you on a specified date. The number of shares you receive is based on the value of the company’s stock at the time they are granted (vesting date). For example, if you are awarded 100 RSUs when the company’s stock is trading at $10 per share, you will receive 100 shares on the vesting date. However, if the stock price has gone up to $20 per share by the time the RSUs vest, you will receive 200 shares.
The major advantage of RSUs over stock options is that you don’t have to worry about timing the market or exercising your options at just the right time. With RSUs, you simply wait for them to vest and then sell the shares if and when you want. This makes them much less risky than stock options and gives you guaranteed value at some point in the future. The only issue is, what if the value of those stock shares falls because the company’s performance suffers sometime in the future? This is why, when accepting RSUs, don’t think the current value of the shares is guaranteed. An important consideration is market conditions, the quality of leadership in your board of directors, the company goals, and whether the grant of these RSUs results in you being compensated less and in doing so, get in the way of your financial goals.
Why offer equity compensation to employees?
There are many reasons why you might want to offer equity compensation to your employees. For one, it can help attract and retain top talent. Equity compensation can also help align the interests of employees with those of the company since they will have a financial stake in the success of the business.
Equity compensation can be a powerful tool for motivating and incentivizing employees. If properly structured, it can help align the interests of employees with those of the company, and create a sense of ownership among employees. Equity compensation can also help attract and retain top talent, as it can be a significant factor in making a job offer more attractive.
When deciding whether or not to offer equity compensation to employees, there are a number of factors to consider. You will need to determine what type of equity compensation plan makes the most sense for your company, and what kind of dilution is acceptable. You will also need to consider the tax implications of offering equity compensation, as well as the administrative burden associated with running an equity compensation plan.
What are some alternative and unexpected benefits of offering your employees equity?
In addition to the more obvious benefits of offering equity compensation to your employees (e.g., attracting and retaining top talent), there are also a number of alternative and unexpected benefits that can be gained from this type of employee benefit.
For example, by offering equity compensation to your employees, you can create a stronger sense of ownership and engagement within your workforce. This can lead to increased productivity and profitability for your business as a whole.
Additionally, offering equity compensation can also help to foster a culture of innovation within your company. As employees feel more invested in the success of the business, they will be more likely to come up with new ideas and solutions that can help to drive the company forward.
Finally, equity compensation can also serve as a powerful tool for attracting and retaining key executives and other high-level talent. By offering this type of benefit, you can ensure that your most valuable employees are incentivized to stay with the company for the long term.
How does the way equity compensation works differ between private companies vs public?
There are a few key ways that equity compensation works differently for private companies vs public companies.
First, with a private company, the pool of potential investors is much smaller and typically made up of friends, family, and venture capitalists. This means that there is typically less liquidity in the market for private company equity.
Second, private companies often have more flexibility when it comes to setting the terms of their equity compensation plans. For example, they can decide to grant employees options or restricted stock units (RSUs) instead of actual shares.
They can also set different vesting schedules and exercise prices. Finally, since public companies are subject to more stringent SEC regulations, they must disclose more information about their equity compensation plans to the public.
How are RSUs, ISOs, NSOs, and ESPPs taxed?
RSUs, ISOs, NSOs, and ESPPs all have different tax implications.
RSUs are taxed at ordinary income tax rates when they vest. This means that you’ll pay taxes on the whole value of your shares when they vest in the year that they vest at your marginal income tax rate. If, for example, your marginal income tax rate is 24% and your shares are worth 100k, you’ll owe 24k in taxes (ouch!).
ISOs are taxed at the time of sale and potentially at the time of exercise. There are three stages with ISOs.
Stage 1. Grant – no taxes, basically ever at this stage.
Stage 2. Exercise your stock options – you may owe “alternative minimum tax” when you exercise your ISOs at this stage depending on the combined value of your salary and the “bargain element” of your ISOs (aka, how much of a discount you received by having ISOs as compared to buying the shares on the stock market at that point in time).
Stage 3. Sell your shares – almost always you’ll owe taxes at this stage. The only time you won’t is if your shares are sold for a price that’s lower than the purchase price built into your ISO and, as a result, you lost money.
NSOs are taxed when they are exercised (the difference between your predetermined purchase price and the current market price of the shares will be taxed as ordinary income) and they’re taxed again when sold (you’ll owe either short or long-term capital gains upon sale depending on how long you own the shares before you sell them).
ESPPs are taxed when the shares are sold as a capital gain based on the difference between your discounted purchase price and the sale price.
Conclusion
Equity compensation is an increasingly popular form of remuneration in a variety of industries. It offers employees the opportunity to share directly in the success and growth of their employer while helping employers create a more motivated and loyal workforce. Knowing how equity compensation works, understanding its advantages and disadvantages, and implementing it correctly can help ensure that everyone benefits. With careful planning, companies can use equity compensation to reward their employees for hard work while creating long-term value for themselves as well.