What is Equity Compensation?
Equity Compensation refers to non-monetary pay that allows an employee to receive a part of ownership in the firm and therefore agrees to work at a lower salary (or zero salary). With this, the company benefits by retaining talent and helps in controlling costs, whereas, employees benefit by way of capital appreciation of shares and large payouts in case the company does well in the future.
Types of Equity Compensation
#1 – Performance Share
Performance shares are issued based on the company’s performance over a period of time and when the company meets or breaks its own target like profits, earnings per share, etc
#2 – Restricted Stocks
These stocks are issued with some conditions, generally given to employees of the company to motivate them and they are restricted to sale or there will be conditions for selling them.
#3 – Non-Qualified Stock Options (NSO)
Non-qualified stock options are a type that allows employees to gain rights over the company for a time period and it does not qualify for tax-exempt. The purchaser has to pay the tax for the difference between the issue price and the original price of the stock.
#4 – Incentive Stock Option
This type of stock options allows employees to get their company shares at a discounted price, but they have to pay tax on the profit from those shares. Generally issued to employees who were valued much and management people. ISO also called qualified or statutory stocks.
Equity Compensation Examples
Lets us consider an example for INCENTIVE STOCK OPTION (ISO), a company has earned high profits and decides to issue ISO kind of stocks to its highly credible and long term employees. Their stocks are issued to the public at $10 per share but as these are being issued to employees they have decided to issue them at $8 per share.
Mr. X who is an employee purchases 100 shares for $8 each and he earns a profit of $10 per share, hence he has to pay tax for that $10 at the end of the financial year.
- Helps to raise capital through employees and maintain a good connection with employees
- Paves the way to employee retention
- Shares don’t move out of a company
- Considered as total reward option which makes the company a good player in high market competition
- Helps startups to raise fund from recruiting employees which makes them remain in company as the company is now in the market.
- Some types of stocks don’t come with ownership rights and for a limited time period, hence ownership will not be issued when the issue of such stock options.
- The employee can enjoy profits from share as well as gain if the share price has increased in the market.
- Some type of equity compensation increases owners and which will dilute the ownership of that company.
- The company will be liable to take back shares which are for a limited period
- If the company doesn’t perform well it be answerable to a large number of shareholders
- Some type of shares doesn’t bear ownership if the company issues such type it may end up in not selling of those stocks.
- It is generally used to encourage and reward high performance. It also helps to retain employees who are well qualified and highly talented. If it is a startup I cannot afford the cost of issuing shares hence it can issue equity shares to qualified employees who were recruited by them.
- Encourages employees to perform well as they were rewarded with shares and it also increases their job satisfaction. The employee will also perform well as they were one of the owners of the company.
This is the best tool for start-up and it does not require cash. It helps to attract new talents into the firm and also reduces the attrition rate. It helps to increase job satisfaction and job retention and the company will perform well in the highly competitive market as it will have highly talented people with them.
This has been a guide to What is Equity Compensation & its Meaning. Here we discuss the types of equity compensation and purpose along with examples, advantages, and disadvantages. You can learn more about from the following articles –