Understanding Equity Compensation

Aug 20, 2019

In addition to salary, some jobs offer perks known as equity compensation. Equity compensation can come in many forms, but what they all have in common is delayed gratification. Equity compensation does not pay off immediately, although it may do so in the long run. If you are fortunate enough to have access to an equity compensation plan, congratulations! But be aware of the nuances associated with various types of plans. Your BFC advisor can help you navigate through the process.

Q: What are the different types of equity compensation?

A: There are five basic types of equity compensation:

  • Stock Options – This type gives employees the right to purchase shares of the company at a given price for a period of time.

  • Restricted Stock – Restricted stock units are a method by which an employer can grant company shares to employees. The shares are "restricted" since they are subject to a vesting schedule. This schedule can be based on length of employment or on performance goals. Restricted stock may also have other limits on transfers or sales that your company can impose.

  • Phantom Stock – This bonus plan doesn’t award employees with company stock itself, but pays them cash based on the stock’s price.

  • Stock Appreciation Rights – This bonus plan pays employees cash based on the increase in the value of a certain number of shares of stock over a specific period of time.

  • Employee Stock Ownership Plans (ESOPs) – These are company retirement plans. A company contributes its own stock (or money to buy its stock) to the plan. The ESOP plan maintains an account for each participating employee. Shares of the stock vest over time.

Q: Why do companies offer equity compensation?

A: In the technology sector, equity compensation has become such a routine expectation that the lack of a plan could be a competitive disadvantage. Some companies, especially startups, offer equity compensation as a cost-cutting measure. They may be able to reduce salaries by dangling a large equity compensation carrot in front of potential employees. In addition, aligning employees’ financial interests with that of the company may incentivize employees to be more productive. Also, since the financial incentive offered by many plans vest over a number of years, these plans can help minimize employee turnover as well as make it more expensive for competitors to poach talent.

Q: What are the disadvantages for employees?

A: Payouts are not guaranteed. While these plans offer the potential for big rewards, a downturn in a company’s fortunes could wipe out any value. There’s also the danger that employees, anticipating a big payout in the future, might feel chained to the company and stay in jobs that they no longer love, or even like. That doesn’t benefit anyone. Finally, if you do receive a reward, the tax treatment can be confusing.

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