Vega Equity is now Xumane

Equity Based Compensation: Comprehensive Guide

  • LinkedIn
  • Twitter
  • Copy
  • |
  • Shares
  • Reads
Author
  • Harvey John Sanya Gupta
Updated: 07 June, 2023
Featured
  • ESOPs

Bootstrapped or cash-burning startups frequently seek methods to reduce their expenses. During the initial stages of development, saving even a small amount of money means having additional resources to reinvest in the startup, enabling faster growth. However, what does it mean to compensate with equity, and why do numerous firms consider it a viable choice?

Especially in startups where traditional salary packages may not always be enough to entice and retain top talent, businesses across various industries are increasingly exploring alternative compensation models.

Imagine a scenario where your employees have the option to receive not only a component of compensation but also a share in the company's ownership. This is the power of equity-based compensation, where employees can choose to accept a reduced salary in exchange for the opportunity to grow with the company.

Sounds confusing, right? Let's unravel this concept for better clarity.

Beyond Salary: What is Equity Compensation?

Although monetary incentives have traditionally served as the standard approach for rewarding employees, this ultimately falls short in terms of effectively retaining them over time. Equity-based compensation, often associated with startups, has transcended its niche, and is gaining popularity among businesses of all types. How can this approach revolutionize the employee experience and drive organizational growth?

Equity-based compensation creates a contract between a company and its employees, helping them to get company shares at a fixed price upon meeting specific conditions. It is a form of non-cash compensation that give employees the potential for financial gains and a stronger sense of ownership in the business. It also aids in retaining employees and accelerating business growth for startups.

In 2022, employees of startups reaped significant rewards from equity-based compensation included in their remuneration packages. A recent report by Inc42 revealed that employees collectively gained $196 million through ESOP (Employee Stock Option Plan) buyback programs implemented by their respective companies. These programs allowed employees to sell their vested shares and realize financial benefits. Alternatively, employees had the option to retain their equity and potentially profit from its future sale.

Salary + Equity: Combining for Comprehensive Compensation

Esop compensation

  • Ownership: Equity compensation provides employees with a sense of ownership in the company by granting them shares or the opportunity to purchase shares. In contrast, traditional salary systems do not offer ownership stakes.

  • Long-Term Incentive: Equity compensation serves as a long-term incentive that aligns employee interests with the company's success. As the company prospers, employees with equity have the potential to benefit financially. Traditional salary systems, on the other hand, primarily focus on providing immediate income for the work performed.

  • Risk and Reward: Equity compensation carries inherent risk and reward. If the company performs well and the stock value increases, employees with equity can experience significant financial gains. Conversely, if the company struggles, the value of equity may decline or become worthless. Traditional salary systems, on the other hand, do not involve this level of risk and reward tied to the company's performance.

  • Cash Flow Considerations: Equity compensation can be advantageous for companies, particularly startups or those with limited cash flow. Offering equity allows companies to conserve cash by providing non-monetary compensation to employees. In contrast, traditional salary systems require immediate cash outflows to cover employee compensation.

  • Tax Treatment: Equity compensation may have different tax implications compared to traditional salary systems. The tax treatment of equity compensation varies based on factors such as the type of equity plan, country-specific regulations, and the timing of exercising options or selling shares. Traditional salary systems are subject to regular income tax withholding.

It's important to note that equity compensation and traditional salary systems are not mutually exclusive and should be used in combination to create comprehensive compensation that suits the needs of both the company and its employees.

Cracking the Code: 7 Must-Know Terms in Equity-Based Compensation

equity Based compensation

Familiarize yourself with these essential keywords before you delve into equity-based compensation:

Employee Stock Option Plan (ESOP) – This plan allows employees to acquire company stock and become shareholders.

Vesting – The process through which an employee earns the right to purchase the stock.

Vesting Period – The designated timeframe within which an employee must fulfill specific requirements to qualify for the benefits of their equity-based compensation plan.

Exercise – The act of buying shares once they have vested.

Exercise Period – The timeframe within which an employee must exercise their stock options after the vesting period concludes.

Exercise Price – The price at which an employee purchases each share.

Grant/Strike Price – The pre-established price at which employees can buy company shares when they exercise their stock options.

4 Types of Equity Compensation

types of equity compensation

Equity compensation comes in various forms, offering distinct advantages tailored to each unique business scenario. There exist five types of equity compensation, each presenting its own set of benefits aligned with the specific needs and goals of the company.

Employee Stock Options Plan (ESOPs) - ESOPs grant employees the right to purchase company stock at a predetermined price, known as the exercise price or strike price. For example, Company X offers its employees stock options that allow them to buy company shares at $10 per share within a specified period.

There are 2 types of Stock options: -

  • Incentive Stock Options – It is a type of stock option that offers tax advantages and is typically granted to top-performing employees. If ISOs are exercised and the shares are sold within one year, the resulting profits are taxed in the same tax slab as ordinary income. However, if the shares are held for more than one year before being sold, the profits are subject to capital gains tax rates. This tax treatment provides an incentive for ISO holders to hold onto the shares for a longer period, potentially maximizing their after-tax returns.

  • Non-qualified Stock Option - In contrast to ISOs, these stocks do not offer the same tax advantages. When employees exercise NSOs, they are required to pay taxes on the difference between the grant price and the exercise price. This amount is typically taxed as ordinary income, or in some cases, a combination of ordinary income and capital gains.
    Due to the absence of specific tax benefits unlike ISOs, NSOs are more frequently awarded as stock options to employees. They provide companies with greater flexibility in granting options, and employees are subject to taxation based on the specific rules governing ordinary income and capital gains.

Restricted Stocks: - RSUs are awards of company stock that vest over time or upon achieving specific performance goals. For instance, Company Y grants its employees RSUs worth 100 shares that will vest over a four-year period, with 25% vesting annually.

Want To Strengthen Your Company’s Equity Management?

Move Away From Manual Spreadsheets to Smarter and Automatic Equity Management Platforms.

Performance Shares: - are a type of equity compensation that link the value of shares granted to an employee with specific performance goals or targets. The number of shares awarded depends on the achievement of predetermined performance metrics.

For example, Company X grants performance shares to its executives based on the company's revenue growth. If the company achieves a 20% increase in revenue over a specified period, executives may receive a certain number of shares as a reward. If the target is not met, the number of shares awarded may be reduced or eliminated.

Employee Stock Purchase Plan (ESPP): - This type of stock provides employees with the opportunity to acquire company stock at more affordable prices compared to the regular market rates. The company extends a discount ranging from 5% to 15% below the fair market value (FMV) of the stock, and the cost is deducted incrementally from the employee's paycheck.

Upon completion of the payment for the stock shares at the discounted price, employees gain full ownership and control of the shares on the designated purchase date.

For more such information on types of Equity Compensation, you can read up on Employee Stock Options for Employee Compensation

From Employers to Employees: What are the benefits of Equity Compensation?

benefits of Equity Compensation

Benefits for Employers

Attracting & Retaining Talent – Equity-based compensation helps organizations with attracting highly skilled and motivated employees who stay committed to long-term success.

Motivating & Aligning Interests - When employees have a stake in the company's performance and success, they are more likely to be motivated, take ownership of their work, and strive for excellence.

Cost Management – It helps in conserving cash flow for the company, especially during early stages or periods of financial constraints. By granting equity instead of cash-based incentives, businesses can allocate resources strategically and minimize immediate financial burdens.

Increasing productivity by building a team – Employees with equity compensation will likely do far more than the bare minimum and gets a sense of ownership as they now have a voice through shareholder voting.

Benefits for Employees

Long-Term investment with great ROI - Equity compensation provides employees with the opportunity to benefit financially if the company's stock value increases over time. As shareholders, employees can profit from the growth and success of the organization, potentially generating significant wealth.

Ownership and Job Satisfaction – Employees now have a voice in the company’s decisions and direction. By holding shares, they gain a sense of ownership and the ability to participate in voting rights and company governance, influencing strategic decisions.

Recognition and Appreciation - Being granted equity compensation can be a form of recognition and appreciation for an employee's contributions to the company. It demonstrates that the company values its efforts and sees them as integral to its long-term success.

Equity Compensation Made Easy: Vega Equity

Choosing the right equity compensation tool is crucial for accurate administration, compliance with legal requirements, transparent communication, scalability, data security, and seamless integration. It empowers companies to effectively manage equity compensation programs, enhance employee engagement, and support their growth objectives.

With Vega Equity, employers can grant ESOPs to all the deserving employees within a few clicks and manage the end-to-end allotment with ESOP Pool creation, grants, vesting management, and more. It also offers real-time updates and visibility, a paperless management system, and intuitive dashboards for all stakeholders involved.

For more such information, you can talk to our Vega Equity experts

Wrapping Up

In conclusion, equity-based compensation offers a powerful incentive structure that aligns the interests of employees with the long-term success of the company. By granting employees ownership in the form of different types of stocks, companies can motivate and retain talented individuals while fostering a sense of ownership and potential financial gain. This compensation approach can drive employee loyalty, promote a culture of integrity, and provide significant financial rewards.

However, it is crucial for companies to carefully design and communicate their equity-based compensation plans and decide on the appropriate compensation tool to ensure fairness, transparency, and proper risk management. Overall, when implemented effectively, equity-based compensation can be a valuable tool for attracting, motivating, and rewarding employees in a dynamic and competitive business environment.

Frequently asked questions

When creating an employee compensation plan that includes equity, several factors should be considered such as the appropriate type of equity compensation, like ESOPs or RSUs, based on company objectives and tax implications. Establish vesting schedules to promote employee retention and determine the equity pool size to attract talent while minimizing dilution. Clearly define eligibility criteria for fairness and strategically distribute equity. Communicate the plan’s details, benefits, and risks to employees to ensure understanding and motivation.

To effectively monitor employee equity compensation using a compensation software platform, companies should regularly update equity data to track vesting schedules and exercise dates. Automated alerts and reporting features can help keep track of important milestones and compliance requirements. Providing employees with access to the platform with real-time information on their equity holdings ensures transparency. Additionally, integrating the software with HRMS and financial systems can help to maintain accurate records and streamline reporting and audits.

To determine the right amount of equity compensation for each employee. The employer should consider factors like the employee’s role, experience, and contribution to the company. Also, to evaluate industry standards, the company’s growth stage, and the total equity pool available. Using a compensation software platform can help to analyze these factors and ensure fair and competitive equity allocations that align with both the company's objectives and employee's expectations.

Incorporating employee equity compensation into a startup compensation tool offers several benefits such as helping to attract and retain top talent by providing employees with a stake in the company’s growth and aligning their interests with the organization's success. The tool simplifies equity management and ensures accurate tracking of vesting schedules etc. It also provides transparency, enabling employees to easily access information about their equity, which boosts motivation and engagement.

Table of Content

Related Content