Equity compensation is a non-cash pay an organisation can offer to its employees as ownership in the firm. Equity compensation is provided in different forms, such as stock options, performance shares, and restricted stock. Employees who receive equity compensation could share the company’s profits through appreciation.
Several companies, especially startups, use equity compensation. It is used as a strategy by small companies or startups on a growth phase, who might need a substantial amount of their working capital to invest in business growth or expansion. They might not have adequate cash to lure or retain talented employees. It is during such times companies opt for equity compensation which makes the compensation package looks lucrative. Hence, at times equity compensation means a below-market salary.
In its ideal form, equity compensation can align the interest of individual employees with the goals of the company. This could result in a good camaraderie among all the stakeholders, help improve innovation and longevity of employment. This, in turn, helps create value for the company, for its users and customers and its employees.
Kinds of equity compensation
Companies offer stock options that provide the right to purchase shares of the company’s stocks at a predetermined price, called exercise price. This right allows the employees to gain control of this option after working for the company for a specific time. When option vests, they gain the right to sell or transfer this option. This process helps in employee retention for a longer time.
Non-qualified Stock Options (NSOs) and Incentive Stock Options (ISOs)
There are other additional types of equity compensation, such as NSOs and ISOs. In the case of NSOs, employers do not have to report when they receive this option or when its exercised. ISOs that offer special tax advantages are available only for employees, and not non-employee directors or consultants.
Restricted stocks units indicate a company’s promise to pay shares based on a vesting schedule. While this benefits the company, it does not give any ownership rights to the employees, until the shares are earned and issued.
Performance shares are awarded to employees only when specific metrics are fulfilled. These metrics could include return on equity, earnings per share, or the total return of the company’s stock in relation to an index. Such shares are typically for over a multi-year time horizon.
Benefits and drawbacks for equity compensation
Firstly, equity compensations are a good corporate-finance strategy for startups. Companies that are starting up, who do not have adequate cash to compensate for their new talent, give out equity compensations. Secondly, stock options align the interests of your employees with your company goals. When they are given stock options, they feel more driven to work for the benefit of the company. This helps in employee retention. Moreover, the company’s ability to provide rewards increases your employee value proposition. This also makes a company a competitive player in the market.
However, founders sometimes go overboard when offering equity pay and wind up, giving away too much ownership of the company. This could be avoided with careful strategic planning. According to the National Centre for Employee Ownership, 76% of employees who are eligible for stock options, end up opting for them. Hence, if you plan to offer equity pay to your teams, the majority of them end up taking them. This creates more work for the compensation department.
With equity compensation, there is no guarantee that this would pay off. Unlike your paid salary, you could never be sure whether this would pay off or not. However, a negotiation based on fair, balanced terms with both equity and cash components is considered to be a good deal.