Let’s suppose that you’re starting up a business or that your company is growing. You need to attract high-quality employees, but cash is tight. Paying extremely high salaries to hire talented employees isn’t really an option. What’s a good way to solve this problem?
An equity compensation plan may be the answer. It gives talented people a good reason to come to work for your company and stay for the long term. But, what is equity compensation? How does it work? And what are the advantages and disadvantages of giving employees shares in your business.
What Is Equity Compensation?
Equity compensation, also known as an equity grant, is a noncash way to compensate employees. It gives them a part ownership interest in their employer’s company. This means the owner is giving up part ownership in the business by granting shares to the employees.
Equity compensation plans are usually combined with reduced salaries. Employees are willing to accept lower salaries in exchange for equity because they expect the return will be higher over the long term.
Employees don’t usually receive shares of the company on their first day at work. They have to wait to become vested, which can take several years. The idea is to give the employees a reason to stay with the company rather than looking for another job.
A typical vesting plan has a 1-year “cliff” and takes 4 years to become fully vested. This means if an employee leaves before putting in 1 full year of work, they would receive nothing. If they continue working, their vested percentage of specified shares would increase by 25% for each year they remain with the company until fully vested.
What if the employee’s company is acquired before they are fully vested? The vesting schedule typically is accelerated so that the employee doesn’t lose interest.
How to Give Employees Equity
Here are the most common ways to share equity with employees:
A popular form of equity compensation for most private companies, especially startups, is stock options. This is a contract that gives the employee the right to purchase a specified number of shares of stock at a strike price, also known as the exercise price, for a certain period of time, called the exercise window. The value for the employee is the price of the company’s stock will increase over time. Also, the employee will be able to exercise the option to buy the stock at the lower strike price and make a profit on the increase.
Suppose Company ABC gives its employee, Angela, an option to purchase 500 shares of the company’s stock subject to a 1-year cliff and 4-year vesting schedule at a strike price of $1. Angela stays with the company for 4 years and is fully vested with her stock option.
The assessed fair market value of the company’s stock has risen to $10 a share. If Angela were to exercise her total option, she would have a gain of $4,500 “on paper” (500 shares times $10 less $500 to purchase the stock).
Stock options don’t give the employee any voting rights until after the options have been exercised and the employee has become an actual holder of shares
Employee Stock Purchase Plans
With employee stock purchase plans (ESPPs), the company gives employees the right to purchase shares at a discounted price.
The employee must use their own funds to purchase the stock. Purchases are usually made through a payroll deduction plan with funds accumulated toward buying company stock at a future date. Employees can set the amount that they want to purchase from each payroll period, but there is usually a maximum percentage of an employee’s salary limitation.
Employees own the stock immediately after purchasing through their ESPP. The stock can be sold for short-term cash or held as a long-term investment.
Restricted Stock Awards
Restricted stock awards are shares that grant the holder a portion of ownership in the company based on a vesting schedule. However, these shares are usually non-transferable, have limited voting rights and only can be traded in accordance with certain regulations. Note that restricted stock is typically only offered to high-level executives and directors of the business.
Restricted Stock Units
Restricted stock units (RSUs) are promises made by the company to an employee to grant a certain number of shares at a specified time in the future. Since RSUs are a promise to offer stock at some point in the future, they don’t represent actual stock ownership. As such, they don’t have any voting rights until the employee has converted the RSUs into shares. RSUs are also known as “letter stock.”
What Are the Benefits of Equity Compensation Plans?
Equity given to employees is an effective way to attract and retain valuable employees. It encourages employees to stay with the company, hopefully long-term, or at least until they become vested in their equity grant plan.
The employee’s interest in working to build the business is aligned with the owner’s desire to improve and expand. If the company grows its profits and increases its valuation, both the owner and the company’s employees benefit. As employee-owners, workers develop a team spirit and want to make valuable contributions to the business because it is in their interest to do so.
Rewarding employees with equity doesn’t affect a company’s bottom line income. Salaries are expenses that reduce net income, but equity is not an expense and doesn’t affect reported income. This is a benefit for the employees as well because it allows the company to maintain a solid financial position and to be able to hire more and better employees.
Conserving cash is a major benefit of equity compensation plans. Companies that are startups or in rapid growth stages need to conserve cash to fund the increase in assets. Paying large salaries for highly talented employees drains cash from the business. Equity grants save on cash flow because employees are being paid at lower salaries.
What Are the Disadvantages of Equity Compensation?
The biggest disadvantage is that you’re giving up part of the ownership in your business. An owner could lose control of the business by giving away too much ownership in the company. Even if an owner maintains majority control, employees with an equity interest will feel they have more right to voice their opinions about decisions in the company. Also, the owner will be obligated to listen to their views.
Equity compensation can be complex. It has significant implications for taxes, accounting and legal issues. There are additional reports to file and regulations to follow, too.
An equity compensation plan has to strike the right balance between too little and too much. You want to give away enough equity to attract the employees’ interest so they can justify taking a smaller salary but not so much that you lose control.
What If You Have an LLC, Not a Corporation?
Equity compensation plans for limited liability companies (LLCs) are different from corporations since they don’t have common shares to offer employees. For an LLC, you can offer either capital interests or profit interests.
A capital interest means the employee would get a certain percentage of the valuation of the LLC at the time of the grant. For example, if the LLC is valued at $750,000 and the employee was offered 1% capital interest, that would be worth $7,500 for the employee.
A profits interest in an LLC gives the employee the right to share in the future income of the LLC plus a share in any appreciation in the value of the LLC.
Suppose the company had a value of $500,000 on the day when the profits interest was granted and the business was later sold for $1,500,000.
An employee with 1% profits interest would receive 1% of the appreciation in value or $10,000 (1% of $1,500,000 less $500,000) in addition to their percentage share of the accrued profits.
How Are Equity Grants Taxed?
The rules that regulate taxes on stock that employees acquired through equity compensation plans are complex. In some cases, taxes must be paid on the date of acquisition at ordinary income rates, while in other situations, taxes might be based on the long-term gain in the price of the stock.
Each situation is different and depends on the details of each plan. The best advice? Consult with your tax professional to determine the consequences of your particular plan and how it will affect employees.
Equity compensation plans can be complex and have different tax consequences for each employee. You want your plans to be simple to understand so employees see the benefits of accepting equity in exchange for lower salaries.