What is Equity Compensation?
Equity compensation is a form of non-cash payment offered to employees, including stock options, restricted stock, and performance shares. These investment vehicles represent a form of ownership in the company for its employees.
Offering equity compensation enables employees to partake in the company’s success through stock price appreciation, fostering long-term commitment and loyalty especially when tied to vesting periods.
Key Takeaways
- Equity compensation represents non-cash payments given to employees in forms such as stock options, restricted stock, and performance shares.
- This compensation form allows employees to share in the company’s profits, encouraging retention through vested equity ownership.
- Often seen in public companies and startups, equity compensation can be an attractive substitute for higher salaries.
Why Equity Compensation?
The use of equity compensation is prevalent among both public and private companies, especially startups looking to attract top talent without straining their cash flow. By offering equity stakes, these companies can align employee interests with long-term business growth.
However, it’s important to note that unlike a guaranteed salary, the financial benefits of equity compensation are not immediate. Payouts depend on how well the company performs over time.
Types of Equity Compensation
Stock Options
Companies may grant stock options, which offer employees the right to purchase company stock at a predetermined exercise price. These options typically vest over time, rewarding employees for long-term tenure. An employee may exercise, sell, or transfer these options once vested and fulfill specific conditions.
Also, it’s important to remember that stock option holders are not considered stockholders and wouldn’t have shareholder rights. Tax implications exist for exercised versus non-exercised options, demanding careful navigation of applicable tax rules.
Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs)
Further subdivision includes Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs). ISOs, reserved exclusively for employees, carry tax advantages providing benefits over NSOs. For instance, NSOs grant employers flexibility to not report options until exercised, offering notable tax reporting benefits.
Restricted Stock
Restricted stock obliges employees to satisfy vesting conditions, which may involve completing a specific time period. Vesting can occur all at once or incrementally across multiple years, as deemed fit by company directives. Restricted Stock Units (RSUs) mirror this approach with companies promising shares upon fulfillment of conditions.
Performance Shares
Performance shares are earned upon achieving pre-specified performance criteria such as earnings per share (EPS) targets or return on equity (ROE). These shares usually cover long-term, multi-year performance periods and underline achievement-driven compensation aligned with the company’s goals.
Understanding these facets of equity compensation enables employees to grasp its potential benefits while companies can effectively harness this strategy to incentivize and retain their critical workforce.
Related Terms: employee benefits, stock options, restricted stock, startup companies, equity stakes.
References
- Internal Revenue Service. “Equity (Stock) - Based Compensation Audit Techniques Guide (August 2015)”.
- Financial Industry Regulatory Authority (FINRA). “Employee Stock Awards: Five Questions Workers Should Ask”.
- Internal Revenue Service. “Topic no. 427, Stock Options”.
