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 salaries). With this, the company benefits by retaining talent and helps in controlling costs.
In contrast, employees benefit from capital appreciation of shares and large payouts if the company does well in the future. Equity compensation is the best tool for a startup and does not require cash. It helps attract new talents into the firm and reduces the attrition rate. It helps to increase job satisfaction and retention, and the company will perform well in the highly competitive market as it will have highly talented people.
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How Does Equity Compensation Work?
Equity compensation refers to the concept of compensating the employees in the form of equity shares rather than salary payment. The employees get ownership right in the business through either stocks, or stock options or any other kind of equity instruments.
Instead of providing the employees with salary or bonuses in a traditional manner, the companies give them equity shares as an equity compensation plan. It can be given in the form of stock options, restricted stocks, employee stock purchase plans, and so on. It helps the company align its own interest with that of the employee so that they perform in their best interest keeping in mind the future growth and expansion prospects of the business which is tied to prices and performance of stocks in the market.
Companies also use this concept as a tool to retain useful and dedicated talent for a long time because employees feel a sense of ownership and belongingness towards their employment. It encourages them to stay and reap the rewards of their own hard work.
Such ownership-related investment vehicles also give the businesses a chance to hire candidates at a salary that is below the market standards because the rest of the compensation is given in the form of stocks, which proves to be beneficial from the point of view of cost control of the business. Any company, private, public, or start-up, may use this method in their operational strategy.
The commonly used types of this compensation strategy are given below. Let us learn the details about how and when equity compensation plan is used and in what way each of them is useful for the business.
#1 – Performance Share
Performance shares are issued based on the company’s performance over a while and when it meets or breaks its target, such as profits, earnings per shareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is., 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 optionsNon-qualified Stock OptionsNon-qualified stock option is the set of ESOPS in which the employee is required to pay income tax at a favourable price. This favourable price is the difference between the grant price and the exercise price of the share. are a type that allows employees to gain rights over the company for some time, and it does not qualify for tax-exempt. The purchaser has to pay tax for the difference between the issue price and the original price of the stock.
#4 – Incentive Stock Option
This type of stock optionStock OptionStock options are derivative instruments that give the holder the right to buy or sell any stock at a predetermined price regardless of the prevailing market prices. It typically consists of four components: the strike price, the expiry date, the lot size, and the share premium. allows employees to get their company shares at a discounted price, but they have to pay tax on the profit from those shares. They are generally issued to employees who are valued much and management people. ISO is also called qualified or statutory stocks.
We can understand the concept of internal equity compensation with the help of a suitable example, as given below.
Lets us consider an example for INCENTIVE STOCK OPTIONINCENTIVE STOCK OPTIONIncentive Stock Options, also known as Qualified Stock Options, are employee compensation type that gives them the right to buy the Company’s stock at a price lower than the current market price. Furthermore, businesses use them to retain their top-tier employees for the long run. (ISO). A company has earned high profits and decided to issue highly credible and long-term employees ISO stocks. They issue stocks to the public at $10 per share, but since they are issuing to employees, they have decided to issue them at $8 per share.
Mr. X, an employee, purchases 100 shares for $8 each, earning a profit of $10 per share. Hence he has to pay tax for that $10 at the end of the financial year.
The concepts of internal equity compensation serves several purposes as given in the list below.
- Companies use it generally 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 recruited by them.
- It encourages employees to perform well as they are rewarded with shares and increases job satisfaction. The employee will also perform well as they were one of the company’s owners.
- It also helps attract good skilled and experienced professionals who can contribute their knowledge for the growth and expansion of the business in return for ownership interest in it.
- It reduces the cost of hiring candidates because there can be paid lesser compensation as compared to market standards and give the rest in the form of equity shares.
- The above point brings to light that the business is able to save a lot of cash outflow and use it as cost cutting initiative along with gaining the advantage of high level of skill and experience.
- Employees start taking initative to build a long term plan of good business performance because their good work will help the business achieve profitability that is in turn tied with the share prices.
- Overall, it is a useful method whereby companies can attract, motivate and use skill and experience of individuals who an help the business achieve greater heights.
Here are some of the advantages of the concept of equity compensation planning.
- Helps to raise capital through employees and maintain a good connection with employees
- Paves the way for employee retention
- Shares don’t move out of a company
- Considered as a total reward option which makes the company a good player in high market competition
- It helps startups raise funds by recruiting employees, which makes them remain in the company as the company is now in the market.
- Some types of stocks don’t come with ownership rights, and for a limited period, ownership will not be issued when the issue of such stock options.
- The employee can enjoy profits from shares and gain if the share price has increased in the market.
A few noteworthy disadvantages of employee equity compensation are given in the list below.
- Some equityEquityEquity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company's balance sheet. compensation increases owners and will dilute the ownership of that company.
- The company will be liable to take back shares for a limited period.
- If the company doesn’t perform well, it is answerable to many shareholders.
- Some shares don’t bear ownership; if the company issues such a type, it may end up not selling those stocks.
Equity Compensation Vs Cash Compensation
The above are two different forms of compensation given to employees within an organization in exchange for the services that they provide to the business. Let us understand the differences between them.
- The equity compensation planning is given in the form of equity shares and the latter is given in the form of salary and bonus.
- In case of the former, the employees gets ownership right of the business whereas in case of the latter, it is not so.
- The former is a compensation that may rise or fall with fluctuation in prices of stocks, proving a risk and unstable form of income. But the latter is a fixed amount the the employee gets in hand every month, which will change only in case of hike in salary or promotion.
- In case of the former, there is less of liquidity because stocks may not perform well or it may not be possible to sell off immediately to get money, whereas the latter is a fully liquid form which the employee can use to pay bills, meet expenses and invest or save.
- The employee equity compensation is a method of employee retention because they will be instigated to perform well in order to increase profitability and market prices of stocks, but the latter is a fixed amount which may not perform this function if the employee is not satisfied with the salary paid to them.
- The former helps business reduce cost and cash outflow, but the latter is a huge cash outflow for the company every month in the form of salary, wage or bonus.
Thus, the above are some noteworthy differences between the two forms of compensation commonly used by companies to hire talent to run the business.
This article has guide to what is Equity Compensation. We explain it with example, differences with cash compensation, types, purpose & advantages. You can learn more about it from the following articles –