Equity compensations are an integral part of the startup landscape. If you are a founder or investor, you have likely heard about equity-based compensation plans.
In a nutshell, equity compensation is as a way to attract and incentivize employees by granting them company ownership. Research suggests that almost half of businesses this year are augmenting job offers and retention plans with bonuses and equity:
Many companies have taken or plan to take non-monetary actions to attract talent. 49% of companies continue to enhance recruitment offers with sign-on bonuses and equity / long-term incentive awards, while over 21% are planning or considering doing so this 2023.
Willis Watson Towers 2023 Compensation Planning Survey
Among other things, what we're seeing is a post-pandemic generation realizing there's more to a job than a decent salary. And while there are many strategies to adapt to new ways of talent acquisition and retention, equity compensations is an even more valuable tool than ever today.
With that said, this guide aims to discuss all things equity compensation:
- What is equity compensation
- How does equity compensation work
- Benefits of equity compensation
- Types of employee equity compensation plans
- How much equity to give employees, really
- Pros and cons of equity compensations
- More FAQs on equity compensations
Equity compensation, explained
What is equity compensation
Equity compensation refers to the practice of offering employees a share in the ownership of a company as part of their overall compensation package. This can take the form of stock options, restricted stock units, phantom stocks, and other types of equity-based awards.
By offering equity compensation, companies provide employees with a direct stake in the success of the business, and align their interests with those of the company and its shareholders.
Equity compensation can be a powerful tool for attracting and retaining talented employees, as it provides a potential financial upside beyond just a salary or bonus.
Employee equity is super important. You want to make sure that employees, especially early employees, who are making a huge commitment and taking a huge risk to bet on your startup are compensated for and have the upside for that in the long run.
Michael Houck, Co-founder at LA-based Launch House
How does equity compensation work
Say you just landed a job at a new company and the hiring manager granted you equity compensation as part of your job offer. This means that instead of receiving cash wages or salary, a certain number of stock options are issued to you as you contribute to the success of the company. As the company's value increases, so do the value of the shares you hold.
This is why equity compensation can be such an attractive option for employees – it gives them a vested interest in their employer's success and rewards them for helping to build that success.
It’s important to remember that equity compensation is a long-term investment, so you shouldn't expect quick returns. For example, if you were granted 10% of common stock, it could take years before the company exits (e.g., gets sold or goes public), and for those shares become liquid assets.
In other words, as an employee, you have to be in it for the long haul and in exchange, you are granted stock ownership stake in the company.
To ensure you fully understand these grants' terms and conditions, all necessary information should be contained in an equity agreement, which you should receive along with your job offer.
Here at Cake, we do this through a combination of "Offer Letter" and "Plan Rules".
The Offer Letter contains details that may be unique to the individual being granted equity (e.g. number of options being allocated, the vesting conditions, and relevant exercise and options price, etc.) In some jurisdictions this is referred to as an Award Agreement or an Option Agreement.
The Plan Rules, on the other hand, are designed to provide a comprehensive overview of how equity compensation works at the startup and the rules that apply to all option-holders. It covers details like:
- The right of the company to buy stocks back from option-holders
- The price at which the company can buy the stocks back from the option-holders
- What happens if an exit event is likely to occur
- Whether the option-holder can transfer his or her options or stocks, and the restriction periods on the transfers
- The company’s right to take certain actions in the shoes of the option-holder, where the option-holder is not cooperating
In addition to the Plan Rules, you may want to read up on more comprehensive guides about equity grants. This will help you understand vesting schedules and dilution in greater detail and give you a better understanding of typical equity compensation in startups.
When it comes to equity compensations in startups, vesting refers to the process by which recipients earn their shares over time. In other words, instead of being awarded all their shares at once (in a lump sum), shareholders receive them gradually over a period of time.
This process is used to incentivize employees and founders to remain with the company for a period of time to fully benefit from their equity compensation. It’s important to note that vesting schedules can vary greatly depending on the specifics of each startup.
Generally, however, vesting periods are most often set up in 4-year increments (with a one-year cliff), which means that recipients don’t receive any shares until they have been employed with the company for at least one year, but after that first year, they typically begin receiving their shares incrementally over the following three years.
Understanding stock vesting and vesting schedule are vital to understanding equity compensation plans.
When employees exercise their option, they are essentially buying shares in their employer’s company at a discounted rate.
To exercise your option, you must pay what’s called an “exercise price” or “strike price”– this is the predetermined price set by the company when awarding options. Once you have paid the exercise price, you own a certain number of shares in your employer’s company.
Exercising stock options can be a great way to build wealth, but it is essential to understand that there are potential tax implications associated with exercising options.
Making equity compensation a piece of cake
Equity compensation plans can be overwhelming for startup founders and employees. Cake removes the complexity out of granting, vesting, and exercising equity compensation – both for startup founders and employees.
Our goal is to provide founders with the tools and knowledge they need to succeed in creating successful businesses through equity-based compensation, regardless of location.
Benefits of equity compensation
There are many benefits Just like the perfect bite of cake, many benefits accompany equity compensation, and we’ll break them down for you.
Benefits to the employee
Equity compensation is an excellent way for employees to get in on the action and benefit from their hard work. Here are some of the key benefits that come with receiving equity-based compensation:
- A sense of ownership and investment in the success of your startup
- The potential to make more money than you would receive through traditional salary payments
- An opportunity to diversify your portfolio, as equity can be used as an asset class alongside other investments
- Tax advantages that may result from holding shares in a private company
- Becoming part of something larger than yourself – it feels good when you know your work is contributing to the success of your startup
Of course, the benefits don’t stop with just the workers! At the heart of it all, equity compensation aims to benefit both employee and employers.
Benefits to the employer
Here are some of the key benefits employers enjoy when offering equity-based compensation:
- Offering potential employees an ownership stake in the company makes it easier to recruit and retain high-caliber talent, helping you build a strong team that is dedicated to achieving success.
- Equity compensations help early-stage startup founders manage cash flow better, giving them the ability to attract top talent without breaking the bank.
- When employees have a stake in their company’s success, they are more likely to be loyal and work hard to ensure its success.
- Depending on the type of equity compensation plan you choose, tax deductions may be available for both employers and employees.
If you’re looking for ways to reward your team while saving money in the long run, then offering equity-based compensation could be just what your startup needs.
The nitty gritty
Types of employee equity compensation plans
Still with us? Great, pour some coffee, stretch your legs, and get yourself a piece of cake. Ready? It’s essential to understand the different types of equity compensation plans that are available so you can decide which is best for your company.
Non-qualified Stock Options and Incentive Stock Options
Stock options are the most common type of equity compensation for startup employees. Stock options come in two varieties: Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs).
NSOs do not offer any tax benefits, but they allow the employee to buy company stock at a set price – known as the strike or exercise price – that is usually lower than the current market value.
On the other hand, ISOs offer tax advantages because they qualify for favorable capital gains treatment upon the sale of the shares by the employee. Certain restrictions must be met to qualify for ISO status, such as holding period requirements and income limits.
Restricted Stock Units (RSU) and Restricted Stock Awards (RSA)
Restricted stock units (RSUs) are grants that eventually become shares of a company’s common stock. The main difference between restricted stock units and other forms of equity-based compensation is that with RSUs, the employee does not receive actual shares at grant.
Instead, their employer holds onto them until certain conditions have been met – such as vesting periods or performance targets – before the employee can receive them.
Restricted stock awards (RSAs) are similar to RSUs, but the employee has immediate ownership of the shares at purchase date of grant. However, they can’t be sold or transferred until certain conditions have been met as well.
Deferred Bonus Plans
Stock Appreciation Rights and Phantom Stock
Two of the most common types of employee equity compensation plans are deferred bonus plans (in the form of stock appreciation rights or SARs) and phantom stock. SARs give employees the right to receive a payment based on the increased value of the company’s stock over time.
The amount received is typically calculated as a percentage of any increase in value since vesting began. Meanwhile, the phantom stock provides recipients with an award that behaves like actual shares but has no real intrinsic value until they convert into cash or other assets.
Employee Stock Purchase Plans
Employee stock purchase plans (ESPPs) are equity-based compensation plans that allow employees to buy company stocks at a discount. The employer usually determines the price, which will be lower than the market rate, allowing employees to save money while investing in their own company’s success.
ESPPs can be structured as either qualified or non-qualified plans, depending on the specific requirements of employers and employees alike. Qualified plans require compliance with specific federal laws, such as those established by the SEC, whereas non-qualified plans do not have any such regulations attached.
In addition, employers may choose to add additional restrictions or benefits to their ESPP plans, such as vesting schedules or performance-based incentives.
For startup founders
How much equity to give employees
So, the next big question is: What’s the right way to distribute employee equity? It can also be tricky to figure out how much cake to give out.
The amount of equity you should provide depends mainly on the position and seniority level of the recipient. A CFO or executive team member might receive up to 15% or more, while entry-level positions could get 0.01%-0.05%.
It’s important to remember that when setting up equity compensation, not all employees should get the same amount. When deciding on a percentage to offer certain positions or individuals, consider the person's role in your company.
For example, someone who is responsible for bringing in new investors might receive more equity than an engineer with similar experience and skillset because their contributions are more tangible.
Pros and cons of equity compensation
Eequity compensation can be a powerful tool for motivating and retaining employees, but it also carries risks and can be complex to implement.
- Alignment of interests. Equity compensation aligns the interests of employees with those of the company. As employees become owners, they are motivated to work towards the success of the company, which can lead to increased productivity and better results.
- Flexible. Equity-based compensation is a flexible option for startups. It allows founders to structure the equity plan to meet their needs and provides incentives to employees that are appropriate for their contribution level.
- Cost effective. Equity-based compensation plans often require smaller upfront costs than traditional forms of employee compensation, such as cash bonuses or salary increases.
- Tax benefits. In some cases, equity compensation can provide tax benefits to both the company and the employee. For example, if the employee receives stock options, they may be able to defer taxes until the options are exercised.
- Motivating factor. Many employees find the idea of owning stock in their company to be highly motivating. This can lead to increased productivity and job satisfaction among team members, positively impacting overall business performance.
- Risky. Equity compensation carries a level of risk, as the value of the company's stock can be unpredictable. Employees who hold equity in the company may see the value of their compensation decrease or disappear altogether if the company's stock price falls.
- Limited liquidity. Equity compensation can be illiquid, meaning that it may be difficult for employees to convert their equity into cash. This can be especially challenging for employees who need cash for expenses like rent or student loans.
- Complexity. Equity compensation can be complex, and it may be difficult for employees to fully understand the terms and conditions of their compensation package. This can lead to misunderstandings and disagreements between the employee and the company.
- Dilution. Equity compensation can dilute the ownership of existing shareholders, which can be a concern for investors. As the company issues more stock or stock options to employees, the ownership percentage of existing shareholders decreases.
Employers should carefully consider the pros and cons of equity compensation and work with legal and financial experts to design a compensation plan that works for their business and their employees.
Cake is built to remove the risks and complexity out of equity management. Bringing decades of experience from startup, scale up, legal, entrepreneurship and fortune 500, we're on a mission to empower founders and their teams by making global equity simple and fast. Ready to get started? Get started today.
More FAQs on equity compensation
1. Is equity the same as salary? Is it better than salary?
No, equity is not the same as salary. Equity-based compensation is a form of indirect payment that gives employees ownership of the company they work for. It can be better than salary if it increases in value over time, but it comes with some risks since its value can also decrease substantially.
2. What is the most commonly used form of equity?
The most commonly used form of equity compensation is stock options.
3. How do you get paid in equity?
Equity compensation is usually paid out in the form of stock options, restricted stocks, or phantom shares.
This article is designed and intended to provide general information in summary form on general topics. The material may not apply to all jurisdictions. The contents do not constitute legal, financial or tax advice. The contents is not intended to be a substitute for such advice and should not be relied upon as such. If you would like to chat with a lawyer, please get in touch and we can introduce you to one of our very friendly legal partners.