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 while and when the company meets or breaks its own target like 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 were valued much and management people. ISO also called qualified or statutory stocks.
Equity Compensation Examples
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 decides to issue ISO kind of stocks to its highly credible and long term employees. 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, 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 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 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 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.
- 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 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.
Equity compensation is the best tool for a startup, 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 article 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 –