Equity Compensation Guide: What Is Equity Compensation & Should You Offer It?
- Human Resources
6 min. Read
Last Updated: 10/25/2023
Table of Contents
As a business owner or human resources professional, you know that an attractive benefits package can help your organization attract and retain top talent. To stand out in today's competitive job landscape, many businesses have started offering equity-based compensation to employees as part of their rewards program. What is this form of compensation, and should you offer it? Read on to explore the basics of equity-based compensation and factors companies should consider when deciding whether to implement it into their reward structure.
What Is Equity Compensation?
Leveraging equity is an alternative form of compensation management beyond or in addition to traditional compensation. Essentially, employers will offer shares of the company to employees, which gives the employee a personal stake in helping to improve company performance.
With an equity compensation plan, employees may be offered shares outright or offered the opportunity to purchase shares at a discounted rate within a designated time window (typically within a certain time of leaving the company). These shares can be offered in addition to, or in some cases in lieu of a portion of, the employee's salary.
Types of Equity Compensation
Companies can offer different types of equity compensation options to employees, and each option provides different benefits and drawbacks for both employees and employers.
- Stock options give employees the right to purchase company stock at a set price, typically below market value, for a specified period of time. If the company's stock value increases, this can net the employee significantly more over time than a comparable amount of standard annual salary.
- Restricted stock involves the award of company stock subject to certain conditions, such as vesting requirements or performance targets. This can be better than standard stock options if the company wants to ensure performance or commitment in certain key areas. Still, it may be less attractive to employees due to the additional restrictions.
- Employee stock purchase plans (ESPPs) allow employees to purchase company stock at a discounted price, usually through payroll deductions. These are typically offered to non-executive employees and are purchased at a slight discount to the current market rate rather than the more attractive prices typically offered to executives via stock options.
- Performance shares award employees shares of stock based on the achievement of certain performance goals. These shares are usually only for upper-level managers and executives and are "awarded" to, not purchased by, the employee.
- Deferred compensation allows employees to defer a portion of their salary or bonus until later, typically retirement. This may allow key employees to control their retirement planning better and accumulate tax-deferred savings. However, employees may feel this compensation is risky if the company isn't relatively stable enough to ensure they will still be operational and financially solvent enough to pay out the deferred compensation by the time the employee reaches retirement age.
Understanding the differences between the various types of equity compensation plans for private companies is crucial for both employers and employees to make informed decisions.
How Does Equity Compensation Work?
When an equity compensation plan is structured properly, employee interests are aligned with shareholder value and company goals in a way that encourages employees to stay highly motivated to work towards a company's success.
Employees are usually awarded compensation equity as part of their overall compensation package, and the details of the equity type, vesting schedule, or performance targets will be outlined in advance as part of the employment agreement.
Once the equity as part of compensation is awarded and any vesting requirements have been met, employees may choose to sell their shares of company stock or hold them as a long-term investment. The value of equity compensation fluctuates based on the company's stock price, and employees are typically eligible to cash in their equity compensation after a certain vesting period or when the company goes public. If the company's stock price increases, employees may realize a financial gain by selling the stock as the company grows and its value increases.
Equity Compensation Benefits
Equity-based compensation plans offer numerous benefits to both the employer and the employee. These plans help align both parties' interests, ultimately improving the organization's bottom line. Additionally, these plans allow for greater flexibility in compensating employees, which can be a key differentiator in attracting and retaining top talent.
Benefits for Employers
Equity-based compensation can help employers improve employee performance by creating a stronger ownership mentality. But offering at least some equity-based compensation instead of traditional cash compensation can also offer these additional benefits to employers:
- More flexibility in cash resources that can be redirected to other company initiatives.
- Increased productivity, innovation, and loyalty from employees who are vested in the company's success.
- Tax benefits to the employer associated with equity compensation plans.
Finally, equity compensation can help create a culture of shared ownership and collaboration within the company, contribute towards a culture of pay transparency, and develop a positive brand image.
Benefits for Employees
Employees also often benefit from seeing a direct link between their hard work and the company's success. Receiving equity in a company can offer significant financial rewards to the employee; as the company grows, so might the value of its equity. This form of compensation can also give employees more flexibility in when and how that compensation is realized. For example, deferred compensation plans can help employees redirect significant earnings to their retirement age. Overall, equity-based compensation plans can be a valuable tool in creating a thriving and engaged workforce.
Equity vs. Cash Compensation
Cash compensation and equity compensation are two very different forms of remuneration for employees.
Cash compensation is the payment of money for work completed, while equity compensation involves the promise or availability of the distribution of company shares. Cash compensation offers greater liquidity and the ability to cover expenses for the employee directly and provides an easily quantifiable reward for their work.
In contrast, equity compensation offers the possibility of significant wealth from the potential increase in the company's value over time. However, equity compensation is often less common, less guaranteed, and requires more time and effort before a financial gain is realized.
Additionally, equity compensation can come with tax implications, as the financial benefit of holding shares is taxed differently than the monetary benefit of cash compensations. For employees, it's important to understand the pros and cons of each form of compensation and its impact on their individual financial goals.
|Cash Compensation||Equity Compensation|
|Refers to payment of money for work completed||Refers to the promise or availability of the distribution of company shares|
|Offers greater liquidity||Offers the possibility of financial gain based on the potential increase in a company's value|
|Legally mandated for employment||Employee benefit|
|Paid to employees on a regular basis||May not result in any financial gain for employees (for example, if the company fails)|
|Taxed as income||May be taxed as either income or capital gains/loss if options are exercised and sold|
Is Equity the Same As Salary?
When considering compensation, it's important to differentiate between salary and equity. While salary represents the fixed pay an employee receives for their work, equity is a form of ownership in a company. While equity is different from salary, it is an important component of a comprehensive benefits package.
Calculating Equity Compensation
When offering equity compensation to employees, it is important to understand how to calculate the value of equity compensation to ensure it is offered fairly to the employer and employee. The calculation of equity compensation will depend on the specific type of equity being awarded and the terms of the award.
One formula that can be used to calculate the value of equity compensation is (Valuation of company/Post-money valuation) x number of equity shares. In this formula, the "valuation of the company" refers to the company's estimated worth, calculated by considering various factors such as revenue, cash flow, and comparable transactions. The "post-money valuation" is the valuation of the company after a new set of shares has been offered to the employee(s).
To simplify this calculation, many business owners use an equity compensation calculator, which can factor in additional variables such as growth projections and stock option vesting schedules. By accurately valuing equity compensation, businesses can better attract the talent they need to grow and succeed.
Is Offering Equity As Compensation Right for Your Business?
As a business owner, offering equity compensation can be a powerful tool for attracting, retaining, and motivating employees. However, it's important to understand the pros and cons of this type of compensation before implementing it. The main points to consider include how equity compensation may impact cash flow, the dilution of ownership, and the potential tax implications for the business and its employees.
When determining your suite of employee benefits, it's critical to work with a payroll services provider that can provide seamless online administration. Contact Paychex to help you create a comprehensive employee benefits package that is both competitive and compliant.