Equity Compensation: What It Is, Types, Pros & Cons
Understanding the details surrounding your equity compensation can help you make the most of your benefits.
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What is equity compensation?
Equity compensation, also called stock-based compensation, refers to noncash pay that provides an ownership stake in a company. Examples include stock options, restricted stock units, employee stock purchase plans and more. Equity compensation can be given to employees and sometimes outside service providers, such as contractors, advisors, directors or consultants.
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Types of equity compensation plans and benefits
There are many types of equity compensation and each has its unique characteristics and preconditions to meet.
Employee stock options
Stock options give you the right to buy a certain number of company shares at a set price during a specified period if you’d like to do so. There are two types of employee stock options: incentive stock options and nonqualified stock options. Both are usually subject to vesting but differ in tax treatments and who is eligible to receive them.
» Got options? Plan for when to exercise stock options
Restricted stock units
With RSUs, your company promises to grant you a certain number of company shares upon vesting (though there may be additional conditions to satisfy). Unlike stock options, employees do not need to pay for company shares, but the vesting date triggers a tax liability.
» Ask an advisor: How are RSUs taxed?
RSUs differ from restricted stock awards, or RSAs, which are company shares doled out on the grant date. Though employees gain ownership of the shares at the time they’re granted, they’re typically still subject to a vesting period. Employees may be required to purchase the RSA shares. But since RSAs are generally awarded to early employees of a budding company, purchasing at fair market value usually means purchasing shares at minimal or no cost.
However, don’t confuse RSUs and RSAs with “restricted stock.” Restricted or control stock refers to securities acquired in a private offering or transaction that are not registered with the U.S. Securities and Exchange Commission and are entirely unrelated to equity-based compensation. Often restricted stock is held by officers or “control persons” who can significantly impact the company’s direction or have access to insider information. These shares are also subject to resale restrictions under SEC Rule 144.
» Ask an advisor: RSUs vs. stock options
Employee stock purchase plans
ESPPs provide employees with the opportunity to purchase shares of company stock at a discount from fair market value, commonly through after-tax payroll deduction. There are both qualified and nonqualified ESPPs; qualified ESPPs offer preferential tax treatment.
Performance shares
Upon meeting specific performance-related goals, you may attain performance shares. These awards are frequently allocated to company executives and directors as an incentive to achieve particular performance targets.
Stock appreciation rights
With SARs, you have a right to the monetary equivalent of the appreciated value of your company’s share price for a set number of shares over a particular period. You may receive the value of your rights in cash or in shares.
Phantom stock
Also known as synthetic or shadow stock, phantom stock is a contract that mimics the perks of stock ownership without actually receiving company shares.
The value of your phantom stock moves in tandem with the actual company stock price, and you’ll earn cash rewards based on how much your phantom shares appreciate over time.
Though phantom stock is based upon a company’s equity or share price, technically, these plans are considered a type of nonqualified deferred compensation plan (see below) rather than an equity-based compensation plan.
Deferred compensation
Though not equity-based compensation plans, nonqualified deferred compensation plans (also known as supplemental executive retirement plans or elective deferral plans) are worth mentioning. NDCPs can be offered along with other forms of equity compensation, particularly to key employees. NDCPs allow employees to postpone income (salary, bonus or other eligible cash payments) to a later date. Doing so can help employees target specific future goals and put taxes off later as the income grows tax-deferred within the plan.
Pros and cons of equity compensation
Boost earnings with stock-based pay received in addition to a salary or other cash-based compensation.
Share in the company’s growth.
In some cases, receive preferential tax treatment.
Typically require meeting certain conditions, such as abiding by a vesting schedule.
Tax liability may be complex and require planning.
In some cases, the benefit may be worthless if the company’s stock doesn’t perform as expected or if you leave before the vesting period is fulfilled.
What to consider about equity compensation plans
Each equity compensation plan’s details and restrictions vary, so it’s essential to take the time to read through all of the fine print.
Remember equity compensation when negotiating any potential pay package. It’s one lever that could boost your overall earnings but it comes with its own set of risks.
Prepare for any financial and tax consequences that may impact you now and in the future.
Seek a second opinion from a financial advisor well versed in equity compensation to ensure you’ve considered all relevant nuances when devising your plan of action.
Why employers offer equity compensation
Equity compensation can be a nice perk for employees, but it also offers an upside to employers. Employers may offer equity compensation to:
Attract and retain talent. Since the potential for a hefty payout is appealing, equity compensation benefits are often used to woo top talent. Because they typically follow a vesting schedule, equity compensation can entice workers to stay longer to avoid leaving money on the table.
Instill ownership. Having a stake in the company may help to align your incentives with that of your employer. Because the value of your equity compensation increases with the growth of your company’s share price, the thinking goes, you’ll have extra motivation to enhance productivity and stay committed to your company for the longer term.
Free up company cash. Companies may offer equity compensation in place of a high salary to help manage their cash flow. Reducing the amount paid out in cash can be especially meaningful to smaller companies and startups that may have limited cash on hand to attract top talent. Additionally, companies that offer equity compensation may earn a tax credit, minimizing their federal tax liability.