What is equity compensation?


Many startups use equity compensation as a tactic in the growth phase, where they may require to invest a significant portion of their working capital in business growth or expansion. In such a case, your startup may not have enough money to hire or retain talented employees. Hence, choosing equity as compensation makes the salary package appear lucrative.

What is equity compensation?

Equity compensation is non-monetary pay that enables employees to receive a portion of ownership in the company and accept a lesser compensation as a result. This can boost your startup’s cost management and help retain employees. On the other hand, employees profit from share price growth and hefty payments when the business succeeds.

Why is employee equity compensation important for a startup?

Equity compensation grants employees stock options or ownership shares in return for their labor. It is an important tool for startups for several reasons:

1. Attracting and retaining talent

Startups often lack the resources to provide competitive pay, incentives, and perks. Offering talents a share in your startup's future success through equity incentive compensation can help attract and retain them.

2. Aligning interest

Giving compensation in equity harmonizes employees' and shareholders' interests. Employees are more driven to commit to your startup’s missions and make choices advantageous to your startup in the long run when they’re shareholders.

3. Conserving cash

Startup leaders need to manage their funds to invest in growth and development. An equity compensation plan allows them to incentivize and reward employees without immediately using cash.

4. Long-term focus

Equity compensation promotes long-term instead of short-term focus on your startup’s expansion and profitability. This is crucial since you must make long-term investments and decisions that will pay off.

5. Flexibility

Founders can modify equity compensation to meet business requirements and specific employee needs. For instance, you can design stock options to vest over time or based on performance benchmarks, enabling you to reward and motivate employees in a way that suits their unique circumstances.

6. Minimizing employee turnover

Some type of vesting always accompanies equity compensation to reduce employee turnover. Vesting, which can be performance- or time-based, imposes conditions for equity credit. As a result, before being allowed to acquire shares in the business, employees must complete their terms of employment and meet performance goals. A person loses their shares if they quit during a vesting schedule. Equity is thus a dependable way to maintain employee investment in the company.

7. Improving employee participation 

A startup's initial success depends entirely on its personnel. This base team is what drives your startup's earnings. The value of your startup's shares rises as it posts consistent profits. As a result, employees who receive stock compensation can directly link their diligent work to rising equity value.

What are the different types of equity compensation plans?

Giving employees a share in the company's success through equity compensation allows you to motivate and reward your employees. It can be an appealing form of compensation since it aligns the interests of employees with those of the founders and investors.

Understanding equity compensation includes thoroughly understanding different types of equity compensation, such as stock options, restricted stock units, and performance-based equity.

  • Stock options: The right to buy business stock in the future at a specific price.
  • Restricted stock units: A promise to issue the startup's stock at a later period, subject to some conditions.
  • Performance shares: The startup's stock awarded attaining certain performance goals.
  • Employee stock purchase plans (ESPPs): A scheme that enables employees to get a discount on a startup's shares.
  • Phantom stock: A cash- or stock-based bonus program based on the value of the business equity.
  • Stock appreciation right (SAR): The right to receive cash or shares based on the growth of a company's stock is known as a stock appreciation right (SAR).
  • Restricted stock awards: the award of company stock subject to certain restrictions or conditions.

How is equity compensation calculated?

The calculation of equity compensation may vary depending on the type of equity and the terms and conditions of the equity plan.

It's vital to remember that the calculation of stock compensation can be complicated and that additional elements, such as vesting schedules, forfeiture clauses, and tax ramifications, impact the equity's worth.

The following are some common equity compensation forms and how they are typically determined:

1. Stock options

A stock option is a contract that gives employees the right to purchase a specified number of your startup's stock shares at a predetermined price (known as the "strike price"). The difference between the stock's current market price and the option's strike price is what determines the option's value. For example, if the strike price is $50 and the market price is $100, the option is $50 per share.

2. Restricted stock units (RSUs)

RSUs, or restricted stock units, are a promise made by founders to give employees a certain number of stock shares at a later period. The stock's current market price determines how much an RSU is worth. For instance, if the market price is $100 per share and the company grants the employee 100 RSUs, the RSUs' total value is $10,000.

3. Performance shares

Startups give out performance shares when they meet specific performance goals, such as achieving sales targets or increasing shareholder value. The stock's market price at the time of issuance and the extent to which the employee attains the performance targets define the value of performance shares.

Equity compensation: Key takeaways

In conclusion, equity compensation is a type of incentive startups offer to their employees to give them a stake in the startup's performance, generally in the form of stock or stock options. This kind of compensation can be useful for startups to attract and retain exceptional employees, align employees’ interests with business interests, and reward achievement and long-term commitment. 

There are many ways to offer equity compensation—each with its own benefits and drawbacks, such as stock options, restricted stock units, and performance shares. Ultimately, equity compensation is a powerful negotiation tool for both startups and employees, but careful consideration and understanding are necessary for its effective use.

Disclaimer: LTSE is neither a law firm nor provides legal advice. Before making decisions on matters covered by this post, readers should consult their legal adviser.

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