When it comes to offering employee compensation, the motto is generally “cash is king.” However, startups aiming to attract top talent within their budget constraints need to think outside the box with their compensation strategies — a popular and enticing alternative method used often is equity compensation.
What is equity compensation?
Equity compensation is a strategy used to improve a business’s cash flow. Instead of a salary, the employee is given a partial stake in the company. Equity compensation comes with certain terms, with the employee not earning a return at first.
Startups often try to lure star employees with the promise of equity. Why? A lot of startups are short on cash but can issue shares at will, which allows them to provide equity. This arrangement has a huge upside for the company: It doesn’t have to pay a salary, which may hurt the company’s initial cash flow.
For example, let’s say you hire a chief technology officer. You may pay them a salary that is 35 percent below market rate but, to offset that, you provide them with a certain chunk of equity.
This type of structure is becoming increasingly popular in full-time employment contracts for startup businesses. [Read more about which employee benefits you should offer.]
How is equity paid out?
Each company pays out equity differently. The two main types of equity are vested equity and granted stock. With vested equity, payments are made over a predetermined number of installments delineated by a contract. Granted stock is provided at the beginning of a contract. Although the equity offer may be significant, the employee assumes the risk of accepting equity in place of, or in addition to, a salary.
Bottom Line
Employees must wait to access vested equity while granted stock is available right away.
Benefits of equity compensation
Both employers and employees can reap the benefits of equity compensation as it provides a financially flexible alternative for businesses — particularly those with limited cash reserves for salaries — and serves as an attractive business prospect for employees.
Pros for employers
Offering equity compensation to employees can lead to many financial benefits for employers, including increased cash flow, tax-saving opportunities that offer more flexibility for the business and a workforce that is both happier and more productive, allowing for goals to align with the company’s objectives.
Employers will likely find that those who accept equity compensation work harder, motivated by the understanding that their earnings are linked to the company’s performance.
Equity compensation serves as an enticing offer for new hires, making it an effective tool for recruitment.
Pros for employees
Employees receiving equity compensation will find a range of benefits as their shares could ultimately yield more value over time than a regular paycheck or monetary bonus. Plus, owning a stake in the company not only diversifies employees’ investment portfolios but also fosters a deeper sense of connection and commitment to the company, serving as an extra incentive to work hard.
Disadvantages of equity compensation
Though equity compensation can provide great benefits to employees and employers, employers should be aware of its complexities, which can be a notable downside.
Cons for employers
Employers that offer equity compensation must comply with all reporting obligations and regulatory standards, including tax laws and jurisdictional requirements. However, this compliance puts an additional administrative strain on a company’s existing departments as they must manage tasks like record updating, policy revision and tracking ownership changes, leading to a complex and significantly higher workload.
Cons for employees
Employees may not be able to immediately access their stock options with certain types of equity compensation, either due to performance-related restrictions, employer-imposed limitations on use and sale or vesting schedules. This situation could lead to employees staying with a company that doesn’t suit them until they are fully vested, potentially foregoing higher salaries or opportunities at companies better aligned with their needs and lifestyle.
Furthermore, owning company stock doesn’t guarantee financial returns. While projections can offer an estimate of potential earnings, stockholders are not immune to an unpredictable market, which can significantly affect the final value received from the equity compensation.
Types of equity compensation
Equity compensation comes in different forms.
Stock options
With stock options, employees can buy shares of the company stock at a preset price. In many cases, employees must wait to sell or transfer their options until after a certain amount of time has passed. This vested structure discourages employees from buying equity shares as they start their jobs as instant equity access can give employees less incentive to stick with the business. However, stock options often expire after a certain date, so the employee will eventually have to buy them.
>> Learn More: Stock Options Calculator
Restricted stock
With restricted stock, all recipients must complete a vesting period (this is only sometimes true with stock options). In most cases, restricted stock is offered as compensation to executives and directors rather than employees. Different restricted stock vesting periods may have different ramifications on the rights that executives and directors have as stock owners.
Did You Know?
Restricted stock is typically reserved for executives and directors while stock options are mostly reserved for employees.
Employee stock purchase plans
Employee stock purchase plans enable employees who receive shares after a vesting period not to report them on their tax returns. This structure gives these plans a unique tax advantage. As their name suggests, they’re available to employees only, so you can’t offer them to contractors, consultants or any corporate board members or shareholders whom you don’t employ. You’ll also see employee stock purchase plans referred to as nonqualified stock options or incentive stock options.
Performance shares
This type of equity compensation is awarded only if executives and directors reach certain performance goals. This arrangement incentivizes executives and directors to focus on work that increases shareholder value. Even if the company fails to meet these marks, individuals with outstanding performance may still be given these shares.
Within these types are subcategories that give companies more or less control over how the equity is paid out.
Best practices for using equity as compensation
It is critical to know the structure of the deal and the kind of equity being offered. Sometimes, an employee may discover that the company is not offering equity but rather options to purchase equity. Additionally, there are times when those options being offered are in a different class of equity from that of the founders.
The option plan may stipulate that the employee exercise their options within 60 days of leaving the company. The employee has to purchase equity before knowing if the company will be successful and the equity will have any value.
Asking an employee to take a lower salary and offering unfavorable equity terms is not a winning strategy for any company seeking to hire great talent. Here are some reasonable equity plan options:
- The company purchases the options for the employee, thus assuming the risk and saving the employee the cost of exercising the options.
- The company lends the employee the money to purchase the options and is paid back when the options are liquidated.
- The company extends the option period to 10 years (instead of 60 days) so that the employee doesn’t have to exercise their options immediately and can hold them to see if their value increases over time.
All of these solutions are favorable to new hires since the option period is extended and the employee is not required to pay for the options upfront.
However, a potential employee may encounter an employer that plays hardball in these types of negotiations and presents them with unfavorable terms. In this situation, they should take charge and either walk away or enlist an agent or legal representation to help with the negotiations. It is easy to think that stock options won’t matter in the long run, but then, why take a lower salary in the first place?
Sometimes a company isn’t even willing to negotiate in these instances. A company’s reluctance to compromise can be an indicator to employees of how it treats its employees. At best, it can signal a culture of rigidity. At worst, it can imply that employees may be exploited. Who wants to work for a company like that?
Your employees are the key to your success and finding good ones is hard. When you finally find someone with the right skills who is also a culture fit, you should make sure they feel good about and are committed to your mission. However, if you make a mistake, you do have recourse.
Smart entrepreneurs know that finding good employees is not possible without fair, clear and mutually beneficial employment contracts. They should not take advantage of would-be employees with unfair deals and convoluted contracts.
Potential employees who feel like a certain deal is unfair should consult with an expert. They should ask about the details of similar deals. The cash component of these deals typically is easy to understand; the equity component, not so much.
Max Freedman contributed to this article.
