Employee Equity Compensation
Let’s take a closer look at the different offerings of equity compensation.
Employee compensation methods are a reflection of a company’s work culture. The sensitivity to understand employee needs and sufficiently recognize their contribution to a business reflects in the way compensation packages are designed. Though the par value remains the same, the elements of a compensation package become the differentiating factor. Equity offerings play a pivotal role in this case.
Employee Equity Compensation
Traditionally, employees have been exclusively compensated with cash-based salary packages. Offering shares of company stock were only considered for senior executives who have stayed with the company for several years and are reliable enough to become a shareholder. But with the advent of the startup culture, cash flow has become an issue in the early stages of the business. Yet the best of talent must be recruited in the initial stages to drive exponential growth. Hence the trending types of employee equity plans.
What is employee equity compensation?
Employee equity compensation is a way of offering non-cash benefits to employees. These benefits are granted in various combinations of shares in the company’s stock. The biggest advantage of offering equity is that a company offers value without having to commit cash. Startups are the highest users of equity-based compensation packages as it helps them invite top professionals to their team without parting with their already stringent cash resources.
A startup typically sets aside 10 – 25% of company shares for the employee equity program. The amount of equity granted depends on the employee role and their timing of recruitment. For example, a VP of Sales if hired among the first five employees may receive 10% equity. But if hired at a later stage when the company has established a viable market, the percentage can go down to 1-2%. However, by then share value would have skyrocketed and a 2% share in that stage is worth a fortune.
The different types of employee equity plans may be a lucrative prospect for employees but they have a dilution effect on founder shares. It is in the best interests of a new business to create an option pool at the very beginning to avoid unnecessary hassles to founders. Moreover, at every funding round, investors demand to expand the option pool at the cost of founder shares to maximize the chances of their returns. Then what is the benefit of equity schemes?
Why offer equity compensation to employees?
The greatest advantage as mentioned earlier is, of course, cash conservation. For a new business, employee salaries weigh on financial stability. It is a recurring expense and becomes difficult to manage if the business is struggling to establish a smooth cash flow, which usually takes a few years to gain footing. This in turn affects the financial stability and profitability of a startup.
In this situation, employee equity compensation removes the recurring cash component from the hiring plans and yet offers the employee the value they deserve. However, equity is seldom granted without conditions. Parting with equity is as good as giving away a chunk of the business and deserves utmost caution. Thus all equity schemes are subject to vesting (usually 4-6 years) which gives the company enough time to evaluate an employee’s merit and also focus cash reserves on activities that have a direct impact on accelerating share values.
Types of Employee Equity Compensation Plans
Employee equity compensation plans vary based on the extent of ownership rights they grant and the subsequent tax implications. Every employee has varying needs and depending on the stage of business, there is only so much a company can afford to part with. Broadly, the most common equity grants are employee stock options, employee stock purchase plans, restricted stocks, stock appreciation rights, and phantom stocks. Here is a closer look:
Employee stock options (ESO)
As the name suggests, this type of stock option is used for company employees. They are best suited for entry-level hires, new to the business, and in need of a proper vetting process before being considered for stock ownership. Here is a brief:
What are employee stock options?
Employee stock options grant an employee the ‘option’ to buy a set number of company stocks at a predetermined price once fully vested. The vesting period is usually 4 years with a one year cliff. If an employee fails to meet vesting requirements, they stand to lose all grants.
The predetermined price, also known as the grant price, is a special discounted price granted exclusively to employees. In an ideal situation, the share value will appreciate as the company grows. Thus, after 4 years when the employee exercises their options, they profit from the difference between the grant price and the market price of the shares on that date. In case the share value plummets, an employee can choose not to exercise their options as well.
Types of employee stock option
All employee equity programs are governed by IRS regulations. Though every form of stock options operates similarly, based on their grantees and the taxes they incur, stock options are of two categories:
- ISOs or the Incentive Stock Options are reserved only for employees. They provide flexibility in terms of tax cuts. If the options are held for a vesting period of two years and further for a holding period of one year, the profits are taxed as per capital gains rate as opposed to the regular income tax. ISOs trigger taxes only on sale and neither on grant or exercise.
- NSOs or Non-qualified Stock Options on the other hand can be granted to anyone. They are taxed as per ordinary income tax rates but do not have the limitations of the holding period. These are normally granted to advisors, consultants, and strategic board members.
Employee stock purchase plan (ESPP)
Some forms of employee equity in startups grant employees the right to a set number of shares, while few other types create provisions where deductions could be made from the employee’s salary during their term of employment to avoid a separate purchase mechanism. Let’s explore.
What is an employee stock purchase plan?
An employee stock purchase plan or ESPP allows employees to purchase company equity at a 15% discount from the fair market value. This type of equity compensation is designed in a way that deductions are automatically made from the employee’s payroll component not exceeding $25,000 per year as mandated by the IRS. Generally, employees who already own more than 5% equity in the company are not allowed this benefit. Otherwise, all employees are granted this option provided they have completed one year of service in the company.
This category of employee equity compensation is quite different from the previous two. They do not grant ‘options’ but the stock itself! However, these grants are accompanied by heavy restrictions. Here is how:
What is restricted stock?
Restricted stocks are a form of executive compensation. They are usually granted by established companies to seasoned executives who have demonstrated a reliable association with the business. In this case, executives are granted the stocks as it is, not simply an option to buy. Thus as compared to stock options, where an employee needs to invest money to buy stocks, restricted stock is usually granted at no cost to the employee.
However, employee equity compensation in the form of restricted stocks is always subject to graded vesting schedules and has heavy restrictions on their transfer or resale before completion of the vesting period. They are also known as ‘lettered stocks’ or ‘section 1244 stocks’ and are taxed as ordinary income. The two types of restricted stocks are:
- Restricted stock units (RSUs): These work similar to stock options but differ in the fact that employees are not granted the actual stock, but the rights to the stock. Until the entire stock vests, they do not have voting rights. Neither are they taxed interim. Once fully vested and converted to stocks, RSUs carry voting rights as per the class of shares granted.
- Restricted stock awards (RSAs): These are literal awards granted to deserving executives. Recipients have voting rights from the date of the grant. However, vesting conditions are still applied, but that does not prevent recipients from exercising their shareholder rights.
Stock Appreciation Rights (SARs)
SARs are a unique type of employee equity plan that offers the value of stock in cash. Recipients are not granted actual stock, but the value of a certain amount of shares in cash. Employees are not required to pay any exercise price. The company on the other hand manages to avoid dilution but still adds value to the employee’s compensation package.
SARs are the flexible component of an employee equity program because they can be structured in a variety of ways to advance and support the needs of an employee. They are often granted along with stock options so that the cash component helps employees buy the stocks and balance out any taxes incurred in the transaction. Like all other equity schemes, SARs are also subject to vesting.
Phantom stock is another type of employee equity plan that treats the grantee as a shareholder without actually granting stock or even an option to buy stock. The value of the company’s stock determines the real value of these grants, but while granting to employees, it is given in cash. Phantom stock is taxed as ordinary income.
Employee Equity vs Employee Salary
The choice between employee equity compensation and employee salary has been a long-standing debate. Over the years, industry experts have recognized their importance and realized that they work best when offered together. Here is a brief comparison between the two:
- Payment terms: Equity compensation is regulated by vesting schedules of at least 4 years along with a 1 year cliff period. This means that an employee will be granted equity ownership in phases, while salary components are paid upfront.
- Structure: Equity payments are non-cash variable packages. The idea is that the value of equity shares will escalate from the grant date and reach a large sum over the years when the employee plans to cash in. If the company performs well, this is usually a large amount. On the other hand, salary packages are fixed. Employees know exactly how much money will be credited to their account at the end of every month. Unlike equity which provides an opportunity for a major payday in case of IPOs or high stock prices, salary-based contracts are predictable. No matter the expansion in portfolio, salary structures are fixed as per pay grades.
- Relationship with the company: An employee equity program is a way of including employees into the shareholding structure of the firm. This means that every employee who is a part of this scheme will become partial shareholders of the company upon completion of the vesting period. This ties them to the company. Salary structures do not engage employees in this way. It is a straightforward contractual arrangement.
What type of plan should you use for your employees?
A sensible employee equity compensation scheme must aim at creating an organic relationship between the employee and the company. While employee retention is important for the business, an employee must feel sufficiently motivated to give their best as well. It is seen that employees who are part of equity schemes proactively contribute longer hours at work.
Employee equity programs can only work if the employee finds a reason to stay invested in the business for the longest term. It is seen that, if employees are granted overlapping equity schemes in a way that the ‘cliff’ period is never allowed to lapse, they do not find the need to look for new opportunities. Here are some more equity plan possibilities that may contribute to a successful equity program:
- Ensure recruitment is done with salaries on par with market trends. Equity percentages can be a deal-maker while recruiting competitive talent.
- In case equity is being granted in response to a promotion, it is best to offer equity value similar to current hiring trends
- In the case of outstanding performers and high ranking executives, performance grants are generally done once a year. It is best to offer at least 50% of the equity value they are worth on that particular date
- It is best to design employee equity programs in a way that there is never a blank period. Overlapping schemes allow continuity.
Manage Your Employee Equity on Eqvista
Eqvista is one of the market leaders in equity management software and enables easy issuance, tracking, and management of all types of employee equity plans. Cap tables can be managed manually in the initial stages of a business. But as the company expands and accommodates more stakeholders, considering the heavy price of legal lapses, it is better to automate the process.
Our expert team at Eqvista is experienced in helping clients understand all features of the software and enable easy use in a short span. Read more about our services here and for further questions, feel free to connect with us.