What is Equity Compensation? Explained

What is Equity Compensation?

Equity compensation is a non-cash form of payment offered by companies to their employees. It gives employees a direct or indirect ownership stake in the company, providing a potential for financial gains if the company succeeds. This can be a powerful tool for attracting and retaining top talent, as it aligns their interests with the company’s success.

What is an example of equity compensation?

Examples of equity compensation are Stock options, Restricted Stock Units (RSUs), and Performance shares. Know more about it below.

What is the commonly used form of equity compensation?

Stock options are the most commonly used form of equity compensation globally, especially in startups and tech companies. This is because they are flexible, cost-effective for companies, and offer potentially high rewards for employees if the company becomes successful.

What are the three types of equity compensation?

Stock Options

A stock option is a contract granting the right, not the obligation, to buy or sell a specific number of shares of a company’s stock at a predetermined price (strike price) by a specific date (expiration date). This gives the option holder flexibility to capitalize on potential future growth or protect themselves from price declines, without needing to purchase shares upfront.

Stock-based units

This term encompasses both RSUs and other instruments like performance shares and phantom stock. These grant ownership of actual shares or their value.

Performance-based awards

These include performance shares, stock appreciation rights (SARs), and bonus units linked to company or individual performance. They reward achievement of predefined goals.

What is the risk of equity compensation?

The main risk of equity compensation is that the company’s stock price may not perform as expected. If the price stays flat or goes down, your options may expire worthless, or your RSUs may be worth less than you expected. Additionally, it can take time for shares to vest, meaning you don’t have immediate access to their value.

Advantages of equity compensation

Equity compensation goes beyond a paycheck. It offers employees a tangible piece of the pie, a sense of ownership that fosters a deep connection with the company’s success. This alignment of interests translates into several benefits:

Talent Magnet

Attract and retain ambitious individuals who seek more than just a salary, differentiating yourself from competitors in a tight talent market.

Cost-Effective

Offer competitive compensation packages without burning through precious cash reserves, especially crucial in the early stages.

Engaged Workforce

Ownership motivates employees to go the extra mile, leading to increased productivity, innovation, and a stronger company culture.

Alignment of Interests

When employees have a stake in the game, their goals become intertwined with the company’s success, driving better decision-making and collaboration.

Disadvantages of equity compensation

Dilution of Ownership

Every time you issue equity, existing shareholders’ ownership percentages decrease. This can be a major concern for founders and early investors who want to maintain control of the company. Diluted ownership also means reduced voting power and potential loss of influence over decision-making.

Administrative Burden

Managing and administering equity plans can be complex and time-consuming. This involves legal and accounting expertise to ensure compliance with regulations and accounting standards. Complex vesting schedules, share tracking, option exercises, and tax calculations can all add to the workload and associated costs.

Talent Retention Risk

While equity can be attractive for attracting talent, it’s not a guaranteed retention strategy. Employees might leave before their options vest, leaving the company with diluted ownership and no return on their investment. Relying solely on equity for retention can also create an unhealthy focus on short-term stock price performance over long-term company growth and stability.

Unrealistic Expectations

Overemphasizing the potential financial rewards of equity can create unrealistic expectations among employees. This can lead to frustration and turnover if the expected windfall doesn’t materialize, especially if the stock price underperforms.

Accounting Complexities

Different types of equity have different accounting implications. Tracking and reporting changes in share ownership, fair value estimates, and potential tax liabilities can be complex and impact financial statements.

How do you structure equity compensation?

Define goals and target audience:

What are your goals for offering equity? Attracting talent, retaining key employees, aligning interests with company success?

Who will receive equity? Executives, specific teams, all employees?

Choose the right type of equity:

1. Stock options: Popular, flexible, but risky if the stock price doesn’t rise. Consider strike price, vesting schedule, and expiration date.

2. Restricted Stock Units (RSUs): Direct ownership vests over time, less risky but less potential gain.

3. Performance shares: Reward achievement of specific goals, aligning interests with company performance.

Determine grant size and distribution:

1. Consider factors like employee level, market salary, contribution, and company valuation.

2. Establish vesting schedules that balance employee retention with immediate rewards.

3. Avoid over-diluting existing shareholders.

What is good equity for a startup?

There is no fixed amount for as equity percentage for startups. It totally depends on various amount of factors.

Here’s a breakdown of the common choices at certain stages of a startup:

Startup Stage:

• Pre-seed/Seed: Typically, 10-20% of the total equity pool is allocated for employees at this stage.
• Series A and beyond: As the company matures, the employee pool shrinks relative to other investors, often falling between 5-15%.

Industry and Talent Pool:

• You might need to offer higher equity percentages (15-20%) to attract and retain top talent.
• Lower percentages (5-10%) might be sufficient, but ensure overall compensation competitiveness.

Type of Role and Experience:

• Critical C-level roles: May warrant 5-10% individual equity to attract experienced leadership.
• Early-stage team members: 0.5-2% per person is common, potentially increasing with vesting and performance.

Final thoughts on Equity compensation

By now, you have a good understanding of how to approach equity compensation for your startup or when accepting it as an employee. This is a long-term compensation structure, which would encourage people interested in your startup and willing to work long-term together with the risks involved in it — which is a positive sign.