What Is Equity Compensation?

Retaining talented employees continues to be an issue for businesses across the economy. As employers look to improve company culture and employee benefits, equity compensation is becoming increasingly common. Although this incentive is not direct financial compensation, it allows employees to own company shares and profit from the company’s success. If you’re considering a job offer or a company offer to provide you with equity compensation then you may want to ask a financial advisor if it’s a good move for your financial portfolio.

Equity compensation gives employees access to stock ownership upon meeting specific conditions or company goals. Generally, equity compensation allows employees to exercise (acquire) stock shares at a discount or tax-advantaged way. As a result, employees with equity compensation on the table have extra motivation to stay with their employer and do their utmost to see the company succeed.

Companies offer equity compensation because it’s an attractive benefit that doesn’t require the company to spend more money immediately. In other words, equity compensation can draw in skilled employees without decimating a company’s cash flow. Plus, employees who see equity compensation in their future are more likely to stick around and help the company reach new heights.

How Does Equity Compensation Work?

Equity compensation has a set of requirements for employees to fulfill. Typically, employees must reach a specified amount of uninterrupted employment with the company to qualify for equity compensation.

For example, your company might offer 500 shares of company stock with a five-year vesting schedule. Each year of employment, you can purchase 100 shares. After five years, you have bought a total of 500 shares and are fully vested. From the point you receive your first share onwards, you can sell your shares or hang onto them if you think they’ll appreciate it.

Remember, company stock is subject to market volatility, meaning it can rise or fall. Additionally, banks and governmental entities don’t protect stock value, so your equity compensation might become a poor investment. As a result, purchasing shares only makes sense if you can undertake the inherent risks of investing in a company’s stock.

Types of Equity Compensation

Employers offer equity compensation in a variety of ways, each has its pros and cons and should be evaluated before deciding how beneficial it is to you as an employee. Here are the four ways that employers tend to provide equity compensation:

1. Stock Options

Stock options are non-compulsory benefits allowing employees to buy a specific amount of shares at a preset price. Employees usually have limited time to purchase shares before the opportunity disappears.

Stock options come in two forms: non-qualified (NQSO) and incentive stock options (ISOs). NQSOs are widely available and the government taxes the difference between the employee’s reduced stock price and the public stock price as regular income. In addition, NQSOs incur capital gains taxes.

Conversely, employers usually give ISOs exclusively to company executives. ISOs don’t incur income taxes for the discount employees receive on the stock price. However, executives may have to pay the alternative minimum tax (AMT) instead.

2. Employee Stock Purchase Plans

Employee stock purchase plans (ESPPs) let employees purchase stock at a lower price. However, employees exercise ESPPs through a payroll deduction. In other words, ESPPs work like 401(k) deductions, but the pre-tax dollars from your paycheck purchase company stock instead of going into an investment portfolio. As a result, ESPPs reduce your income taxes and might help you drop into a lower tax bracket.

3. Restricted Stock Unit Grants

Common among startups, restricted stock units (RSUs) are shares an employee receives after working for a company for a specified period. Once the employee is fully vested, they receive a certain number of shares or the cash equivalent of the shares at the current market price. The government taxes RSUs as regular income.

4. Phantom Stock

Unlike the other types, phantom stocks don’t grant employees ownership of actual company stock. Instead, phantom stocks mirror the value of company stocks and provide employees with the cash value of a specific number of stocks upon vesting. Occasionally, employees can exchange phantom stocks for company shares, but they’ll forfeit the cash payment from the phantom stocks.

Pros of Equity Compensation

Equity compensation benefits companies and employees in several ways. For example, the most important benefits of equity compensation are:

Employees can usually purchase shares at a reduced price
Employees have the incentive to stay with the company and work diligently
ESPPs can reduce an employee’s income taxes
Company shares can diversify an employee’s portfolio
Companies can maintain healthy cash reserves while rewarding employees

Cons of Equity Compensation

Companies and employees handling equity compensation packages should beware of the following pitfalls, which each provide some risk to relying on this form of compensation:

The value of company stock can plunge and that means that equity compensation might cost employees money.
Exercising equity compensation might incur income taxes even though employees aren’t selling their shares.
A company might use equity compensation instead of more pay, reducing an employee’s annual compensation.

What Employees Should Know About Equity Compensation

Equity compensation comes with no promise of stock appreciation or a specific level of profit. Like any other company, your employer’s stock might rise or fall depending on overall company performance, market conditions and economic trends.

Therefore, while equity compensation is the icing on the cake for committed, productive employees, it’s not equivalent to monetary compensation. On the other hand, company growth generally results in stock appreciation, so equity compensation is a potentially valuable bonus for helping your company thrive.

The Bottom Line

Equity compensation is a way for companies to entice talented employees with stock shares in return for committing to the organization’s success. This situation benefits both parties by allowing companies to keep more cash and employees to purchase stock at a discount. However, company stock can perform poorly, meaning equity compensation could fall flat as a monetary bonus.

Tips for Understanding Equity Compensation

Exercising equity compensation and selling shares can have unforeseen tax implications. A financial advisor can help you incorporate employer benefits into your financial plan and investment strategy. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Some companies make ownership and equity compensation the entire reason people should want to work for them. One example is an employee stock ownership plan (ESOP), which allows the employees to jointly own and operate the company as a collective group of private shareholders.