What Is Equity Compensation?

Equity Compensation Explained

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Equity compensation is a form of financial incentive that employers offer employees in the form of stock ownership in the company or compensation derived from the share value of the company stock. It is used as a way to lower cash requirements for companies, attract and retain top talent, and align employees’ financial incentives to the success of the business.

Equity compensation plans have rules that often require employees to be employed for a certain length of time before being fully vested. Learn more about equity compensation, and what it means for the individual investor.

Definition and Examples of Equity Compensation

Equity compensation occurs when employers offer supplemental payment to their employees in the form of shares of ownership in the company. It is also known as share-based compensation, and comes in many different formats, such as stock options, restricted stock, or employee stock purchase plans.

Employees who receive equity-based compensation can later take their shares of ownership and sell them on the private or public markets. 

It’s common for employees to receive equity compensation based on their performance, which means the shares are released to the employee once they meet certain performance metrics.

A local tech startup might be trying to attract top talent by offering a favorable salary as well as stock options in the company. This benefits the employee if the shares rise because he or she profits if appreciation happens and it benefits the employer because it can offer non-cash incentives to attract top talent and lower the company’s immediate payroll obligations.

How Does Equity Compensation Work?

A company that offers equity compensation to its employees gives its employees ownership of private or public shares of stock along with their salary. In most cases, the employees have to stay with the company for a certain amount of time to become fully vested in the shares, that is, to have full ownership of the stock. 

Employees who have fully vested can take their shares of stock and sell them to private or public markets for cash, depending on whether the company is privately or publicly owned.

An employer may offer equity compensation to potential employees for many reasons. They may include:

  • Correcting the “principal/agent” problem: This happens when employees don’t have the same incentives as the employer to always do what’s in the best interests of the company. Providing equity-based compensation allows employees to become part-owners in the business, better aligning their interests with the company executives and owners.
  • To lower cash requirements: Companies can save on immediate payroll expenses by offering their employees ownership in the company. This is especially popular for startups that have limited cash flow.
  • To motivate employees: Companies will offer equity-based compensation to motivate employees beyond their paid salary.
  • Hiring and retention: Equity compensation can attract top talent, and help retain key employees due to the financial ties to the company this form of payment creates.

Although equity compensation lowers an employer’s cash requirements upfront, the employer usually pays for it financially because the more shares of the company that are offered to employees, the more diluted the price per share will become. Furthermore, the employer will retain less ownership in the company, should it be acquired or go public, or should an employee sell their shares after being fully vested.

Types of Equity Compensation

There are many different types of equity compensation plans, each coming with different contractual rules for the employees. 

The most popular types of equity compensation plans include stock options, restricted stock, employee stock purchase plans, phantom stock, and stock appreciation rights.

Stock Options

Stock options give employees the right to buy a given number of shares in a company at a stated price and date. Stock options are not ownership in stock, but rather a contract that gives you the right to purchase stock at a stated price and date. A company may give you stock options that state that you can buy 1,000 shares of stock in the company for 50 cents per share after a certain date, for instance. 

That means that after the stated date, regardless of the current stock price, you can purchase 1,000 shares for 50 cents, or $500 total.  If the shares are worth $2 per share at the time you exercise the options, you still only pay 50 cents per share, and make an immediate profit of $1.50 per share, or a total of $1,500, in this case.

Restricted Stock

Restricted stock, also called restricted stock units, or RSUs for short, means issuance of shares of stock that come with limited ownership rights for the employee. Limitations to ownership in the stock usually include a vesting schedule during which the employee doesn’t have full ownership of the shares until a certain length of employment or particular performance metrics have been met. After receiving full ownership of the shares, the employee then has full voting and dividend rights conveyed by those shares.

Employee Stock Purchase Plans (ESPPs)

Employee stock purchase plans (ESPPs) allow employees to use after-tax money deducted from their paycheck to purchase stock at a discounted price, often up to 15% off. Depending on the ESPP rules, in most cases, all employees are eligible to purchase stock at discounted prices.

Phantom Stock

Phantom stocks are contracts that allow employees the right to cash payments that are dependent on stated times or conditions and are based on the market value of the equivalent shares of the company. 

Phantom stock does not represent actual shares in the company; rather it is derived from the share price of the company.

Stock Appreciation Rights (SARs)

Stock appreciation rights are a type of compensation given to employees that allows them to profit from the growth in the value of a stated number of shares of the company stock in a set timeframe. SARs are similar to stock options; however, they don’t come with the imposed exercise prices that are required with stock options.

Pros & Cons of Equity Compensation

Pros
  • Aligns the employees’ financial compensation to the success of the business

  • Provides the employee with potential tax benefits

  • Allows companies to attract and retain top talent


Cons
  • Companies have to give up ownership when offering equity compensation plans

  • Equity compensation plans appear as a non-cash expense on the income statement, devaluing the company accordingly

  • When a company issues more shares of its stock as equity compensation, it dilutes the value of the existing shares


Pros Explained

  • Aligns the employees’ financial incentives to the success of the business: Employees who have “skin in the game” of how well the business does are more likely to act in the best interests of the business. If the employee contributes to the company’s growth, their financial well-being will benefit as well because their net worth is tied to the company’s success.
  • Provides the employee with potential tax benefits: Employees who receive equity compensation will pay taxes on the value of the equity compensation on the day they are fully vested. However, they don’t pay taxes on any appreciation in the value of the shares up to that point. Also, exercising the shares for cash has no cost.
  • Allows companies to attract and retain top talent: Businesses that offer equity compensation plans have a bargaining chip to attract top talent and retain that talent as the company grows due to the vesting rules in most equity-based compensation plans.

Cons Explained

  • Companies have to give up ownership when offering equity compensation plans: Owners of growing companies often will pay a price by giving up ownership when offering equity compensation plans. This devalues their overall financial incentives and potential profits, should they sell the company in the future.
  • Equity compensation plans appear as a non-cash expense on the income statement, devaluing the company: Although companies can lower their cash requirements by offering equity compensation plans, it still shows as a non-cash incentive on the income statement, which will in turn affect company value.
  • When a company issues more shares of its stock as equity compensation, it dilutes the value of the existing shares: The more shares of stock offered by a company, the more it dilutes the value of all the other outstanding shares. If a company is worth $1 billion and has 100 million outstanding shares, that means shares are worth $10 each. However, if it offered 50 million more shares to new employees, while the company is still worth $1 billion, each outstanding share is now valued at $6.67 each.

What It Means for Individual Investors

Investors deciding which companies to add to their portfolio should consider how the company pays and incentivizes its employees because that may affect how to value the company and whether it fits their investment objectives and portfolio standards. For example, if a company is hurting financially, and it also has financial obligations to employees due to equity compensation plans, that could threaten the company’s balance sheet in the future and be something an investor would be wise to note.

Furthermore, how a company pays its employees can affect the overall company culture. Understanding that culture can be a great indicator of how healthy a company is from an investing perspective. 

Key Takeaways

  • Equity compensation is a type of payment that employers offer employees. It can come in the form of shares of ownership in the company, rights to shares of ownership, or cash incentives based on the current share prices of the company.
  • Equity compensation is often referred to as stock-based compensation or share-based compensation.
  • In most cases, there are vesting schedules associated with shares of company stock offered through equity compensation plans.
  • The most common types of equity compensation plans include stock options, restricted stock, employee stock purchase plans (ESPPs), phantom stock, and stock appreciation rights (SARs).
  • Investors should take note of the equity compensation plans offered by companies to help determine the suitability of buying securities in those firms for their portfolios.