What is Equity Compensation and How Does it Work?

What Is Equity Compensation?

Equity compensation is a unique type of employee benefit that gives partial company ownership to the individual members of the organization’s workforce — usually in the form of stock options, restricted shares, performance shares, or employee stock purchase plans (ESPPs). 

Equity compensation encourages ownership by making employees partial owners of the company. The employees can share in the organization’s profits via stock appreciation, and the better the company performs, the more the employee gets out of the deal. As a result, the employee becomes extremely invested in the success of the business, because (unlike a salary that gets paid out regardless of how the stocks are doing) this translates company wins directly into personal wins (i.e. money) for individual members of your workforce.

Why Offer Equity Compensation?

At its core, equity based compensation is about helping employees create a more personal connection with their organization and become more invested in the work they do. That sounds cool, right? But is it a better option than some of the more traditional benefits and compensation strategies?

Sometimes.

Benefits are effective ways to attract valuable talent, and 77% of workers engage with their worker’s wellbeing benefits. On the other hand, some outside-the-box company perks can really start to add up in terms of cost. The Bureau of Labor Statistics suggests that the average compensation costs to employers of private industry workers is currently $40.23 per hour worked, with benefit costs accounting for about 30% of total employer expenses. 

Unlike fixed benefits such as gas stipends, pet insurance, daily catered lunches, etc., equity compensation is directly tied to the performance of the company. The better the company does, the more valuable the equity, so there’s no chance of the benefits draining cash resources that aren’t there. 

Still, probably the most significant other business case for equity compensation is in how it improves employee retention. According to a survey of 408 business leaders, attracting and retaining top talent is the top-reported reason companies decide to roll out an equity compensation plan, making it a tried-and-true solution to employee retention issues. This is particularly true when the equity compensation plan comes with internal vesting requirements (milestones or timelines that determine when an employee takes ownership of their equity award).

And even though we’ve already addressed it, it’s worth reiterating that equity compensation drives employee engagement. Ninety-five percent of HR leaders and 80% of employees agree that equity compensation is the most effective way to motivate employees and keep them engaged.

What to Know About Equity Compensation

Employers and employees agree that equity compensation is valuable. That said, there are a few things you should know before you consider offering it to your employees:

Vesting Periods

Many equity compensation plans require employees to work for a certain length of time before they can exercise their options or receive shares. This requirement is known as a "vesting period." Vesting periods can vary widely, from a few months to several years, and help incentivize employees to remain with the company long enough to begin enjoying the stock-based rewards.

Potential Share Discounts or Tax Breaks

Many equity compensation plans offer employees the opportunity to purchase shares at a discounted price. Additionally, there may be tax benefits associated with certain types of equity compensation plans, such as employee stock purchase plans (ESPPs). However, it's important to note that tax laws can be complex, and employees should consult with a financial advisor to fully understand the tax implications of their equity compensation.

Risk Factors

Equity compensation is not without risk. The value of the shares can fluctuate, and employees may end up with less than they initially expected. Additionally, some equity compensation plans may have restrictions on when and how employees can sell their shares. Be clear with your employees about the risks involved, because one thing you don’t want is a workforce that thinks it’s being cheated out of its benefits.

Varying Levels of Motivation

The potential to own a stake in the company can create a sense of ownership and alignment with the company's goals… but not for everyone. Not all employees are motivated by equity compensation; offering a variety of benefits that appeal to different types of employees will help ensure that no one gets left out. 

Types of Equity Compensation

Employers have a few different options when it comes to offering equity compensation. Here are a few of the common types of equity compensation plans. 

Stock Options

Stock options allow the employee the opportunity to purchase shares of the companies’ stocks at a predetermined price within a specific time frame. The predetermined price is often referred to as an “exercise price”. Employees who have stock options are not considered shareholders, and generally, there are expiration dates and vesting periods associated with the stock options. There are also different types of stock options such as non-qualified stock options (NSOs) and incentive stock options (ISOs). These options have different rules and tax advantages, so employees should consult with a financial advisor to determine what plan works best for them.

Restricted Stock

Employers can also offer employees restricted stock or restricted stock units (RSUs). Restricted stock plans allow employers to issue shares to an employee after a certain time period (known as vesting). Sometimes, employers also require employees to meet additional conditions–such as hitting specific performance goals–in addition to the vesting period before they issue restricted stock. Restricted stock and restricted stock units also generally have sale and transfer restrictions (hence the name) as well as voting restrictions until after the vesting period, but once employees meet the conditions, they are generally considered shareholders.

Employee Stock Purchase Plans

Similar to stock options, employee stock purchase plans (ESPP) allow employees the opportunity to purchase shares of company stock through after-tax payroll deductions. Generally, employers offer these stock options at a discounted rate and handle all the buying on the employees’ behalf.

Performance Shares

Performance shares are just what they sound like–performance driven! In this plan, employers can give out a certain number of shares based on the company’s performance over a certain time period. This type of equity compensation plan is generally reserved for executives and high-level managers. 

Equity compensation plans come in several forms and can be very complex, so it’s a good idea to first clearly define the goals you hope to achieve with your plan. After you define your goals, you should consult the appropriate financial and legal experts in your industry to discover the unique ins and outs for your business. 

“Stock” Up on Top talent

Equity compensation isn’t a one-size-fits-all approach to benefits, but if it makes sense with your workforce and aligns with your company goals then spreading some ownership around can be a great way to make employment personal. And when coupled with a comprehensive benefits package supported by company wellness initiatives, a little bit of equity compensation can go a long way.

Learn more about employee motivation; contact a Wellbeing Specialist today, and get your people invested in their success.