Equity Compensation

Equity compensation is pay in the form of ownership or the right to ownership in the employer’s company rather than (or in addition to) cash. It’s commonly used by public companies and startups to attract, reward, and retain employees, and ties employee incentives to company performance.

Key takeaways

• Equity compensation gives employees an ownership interest or the right to obtain shares.
• Common forms include stock options, restricted stock (and RSUs), and performance shares.
• Vesting schedules, exercise prices, expiration dates, and tax rules determine the value and timing of benefits.
• Equity can boost upside but carries risk and may accompany below-market cash pay.

How equity compensation works

• Grant: Employer grants an equity award (options, RSUs, etc.) with terms describing vesting, exercise price, and expiration.
• Vesting: Employees earn the right to the award over time or after meeting performance conditions. Typical vesting is time-based (e.g., four years with a one-year cliff).
• Exercise/Issuance: For options, vested awards give the right to buy shares at a set exercise (strike) price. For RSUs and restricted stock, shares are delivered once vesting conditions are met.
• Rights and ownership: Option holders are not shareholders until they exercise. Owners of issued shares have shareholder rights (voting, dividends) depending on the share class.
• Liquidity: Public-company shares are usually liquid; private-company equity may be illiquid until a funding round, acquisition, or IPO.
• Taxation: Tax treatment varies by award type, timing, and jurisdiction. Taxes can arise on grant, vesting, exercise, or sale.

Types of equity compensation

Stock options

Employees receive the right to buy company shares at a predetermined exercise price.
* Vesting required to exercise.
* Options typically expire after a set period.
* Option holders are not shareholders until they exercise and acquire stock.

Non‑Qualified Stock Options (NSOs) vs. Incentive Stock Options (ISOs)

• NSOs: Can be granted to employees, consultants, and directors. Usually taxed as ordinary income at exercise on the difference between fair market value and strike price.
• ISOs: Only for employees and can offer favorable tax treatment (potentially capital gains treatment) if holding-period requirements are met. ISOs are subject to specific rules and limits.

Restricted stock and Restricted Stock Units (RSUs)

• Restricted stock: Shares granted subject to vesting conditions; once vested, the recipient owns the shares.
• RSUs: A promise to deliver shares (or cash equal to shares) upon vesting. Holders generally do not have shareholder rights until shares are delivered.

Performance shares

Shares or units granted only if predefined performance goals (e.g., EPS, ROE, TSR vs. an index) are met over a performance period. Used to align pay with measurable company outcomes.

Pros and cons

Pros for employees:
* Potential for significant upside if the company performs well.
* Alignment with company success; retention through vesting.
Pros for employers:
* Conserves cash—useful for startups and growth companies.
* Incentivizes long-term employee performance and loyalty.

Cons for employees:
* Value is uncertain and can go to zero.
* Complex tax implications and potential liquidity constraints.
Cons for employers:
* Dilution of existing shareholders.
* Administrative and regulatory complexity.

Practical considerations for employees

• Understand the terms: vesting schedule, exercise price, expiration, and any post-termination exercise window.
• Know the tax implications at grant, vesting, exercise, and sale; consult a tax advisor if needed.
• Consider exercise timing and liquidity—exercising early can start holding periods for favorable tax treatment but may require cash and carry risk.
• Factor equity into total compensation decisions, especially if cash salary is below market.

Conclusion

Equity compensation can be a powerful component of pay, offering alignment with company performance and potential upside. Its value depends on grant terms, company prospects, market conditions, and tax choices. Evaluate offers carefully, understand the mechanics and risks, and seek professional advice on tax and exercise strategy when needed.