Understanding Equity Compensation

Jun 12, 2019

In addition to salary, some jobs offer what is known as equity compensation. Equity compensation can come in many forms, but what all have in common is delayed gratification. Equity compensation does not pay off immediately, but it may do so in the long run.

Types of Equity Compensation

There are five basic types of equity compensation:

  1. Stock Options – give employees the right to purchase shares of the company at a given price for a period of time.

  2. Restricted Stock – gives employees the right to acquire or receive shares if certain restrictions (e.g. time of service or performance goals) are met.

  3. Phantom Stock – a bonus plan that does not award company stock itself, but pays cash based on the stock’s price.

  4. Stock Appreciation Rights – similar to phantom stock, but the award is instead based on the increase in the value of a certain number of shares of stock over a specific period of time.

  5. Employee Stock Purchase Plans (ESOP) – grants employees the right to buy company stock on a predetermined schedule, often at a discount.

Why Do Companies Offer Equity Compensation?

  1. For some companies, especially startups, offering equity compensation is a way to conserve cash. If a company can dangle a large equity compensation carrot in front of potential employees, it may be able to pay out less in salary.

  2. Such plans further incentivize employees by more closely aligning their financial interests with that of the company.

  3. Equity plans can help minimize employee turnover. Many such plans vest over a number of years, offering a big and ongoing financial incentive for employees to remain on board. They also make it more expensive for competitors to poach talent.

  4. In the tech sector, equity compensation has become such a routine expectation that the lack of a plan could be a competitive disadvantage.

Are There Any Disadvantages for Employees?

  1. Payouts are not guaranteed. While these plans offer the potential for big rewards, a downturn in your company’s fortunes could wipe that out.

  2. If there is a potential big payout in the future, an employee might feel chained to a particular company and be more likely to stay in a job that they no longer love, or even like.

  3. The tax treatment of awards can be confusing for employees.

Summary

If you are fortunate enough to have access to an equity compensation plan, congratulations! Be aware that there are nuances in the various types of plans. Talking to a trusted advisor can be invaluable in helping you navigate.

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