Equity Compensation
REVIEWED BY WILL KENTON Updated Apr 30, 2018
What is Equity Compensation
Equity compensation is non-cash pay that represents ownership in the firm. This type of compensation can take many forms, including options, restricted stock and performance shares. Equity compensation allows the employees of the firm to share in the profits via appreciation and can encourage retention, particularly if there are vesting requirements.
BREAKING DOWN Equity Compensation
Equity compensation has been used by many public companies and some private companies, especially startup companies. Recently launched firms may lack the cash or want to invest cash flow into growth initiatives, making equitycompensation an option to attract high quality employees. Traditionally, tech companies in both the start-up phase and more mature companies have used equity compensation to reward employees.
Common Types of Equity Compensation
Companies that offer equity compensation can give employees stock options that offer the right to purchase shares of the companies’ stocks at a predetermined price, also referred to as exercise price. This right may vest with time, allowing employees to gain control of this option after working for the company for a certain period of time. When the option vests, they gain the right to sell or transfer the option. This method encourages employees to stick with the company for the long term. However, the option typically has an expiration.
Employees who have this option are not considered stockholders and do not share the same rights as shareholders. There are different tax consequences to options that are vested versus those that are not, so employees must look into what tax rules apply to their specific situations.
There are different types of equity compensation, such as non-qualified stock options (NSO) and incentive stock options (ISOs). ISOs are only available to employees and not non-employee directors or consultants. These options provide special tax advantages. With non-qualified stock options, employers do not have to report when they receive this option or when it becomes exercisable.
Restricted stock requires the completion of a vesting period. This may be done all at once after a certain period of time. Alternatively, vesting may be done equally over a set period of years or any other combination management finds suitable. RSUs are similar, but they represent the company’s promise to pay shares based on a vesting schedule. This offers some advantages to the company, but employees do not gain any rights of stock ownership, such as voting, until the shares are earned and issued.
Performance shares are awarded only if certain specified measures are met. These could include metrics , such as an earnings per share (EPS) target, return on equity (ROE) or the total return of the company’s stock in relation to an index. Typically, performance periods are over a multi-year time horizon.
Example of Equity Compensation
For instance, LinkedIn’s stock-based compensation in 2015 was $510.3 million, up from $319.3 million the prior year. In 2015, it represented over 17% of revenue. Over $460 million of the total was in the form of restricted stock units (RSUs).SPONSORED
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Related Terms
Stock Compensation DefinitionStock compensation refers to the practice of giving employees stock options that will vest, or become available for purchase, at a later date. moreNon-Qualified Stock Option (NSO)Non-qualified stock options are an alternate way of compensating employees. moreWhat You Need to Know About Sweat EquitySweat equity is the unpaid labor employees and cash-strapped entrepreneurs put into a project, whether it’s a start-up venture or renovating a property. moreGrantA grant is an award, typically financial, from one entity to another, the latter typically an individual, to facilitate a goal or incentivize performance. moreStock Appreciation Right (SAR) DefinitionA stock appreciation right, or SAR, is a bonus given to an employee that is equivalent to the appreciation of company stock over a specified period. moreRestricted Stock DefinitionRestricted stock refers to insider holdings that are under some kind of sales restriction, and must be traded in compliance with special SEC regulations. morePartner Links
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Getting Paid in Equity: Is It Right for You?
by Allison Canty — Published in News & Updates on July 29, 2010
Equity-based pay is often used by the founders of young startups who want to grow their businesses but cannot offer big salaries to qualified professionals. Typical arrangements seek to either partially or fully compensate service providers with stock in the company in exchange for hard work.
Depending on where you are at (career- and age-wise), as well as where the company is at –and where it is going– this offer could either be an amazing opportunity, or it could be a total waste of your time and potential.
Below are some helpful tips and suggestions to keep in mind when contemplating whether or not to take an equity-based position.If you’re looking for more information on equity, check out our comprehensive guide on Business Equity for Entrepreneurs.
Gauge The Company’s Ability To Sell
Equity compensation can be a lucrative investment of your time if you work for the right business. When deciding whether to accept such an offer, you must perform a sort of risk assessment of the company, including their ability to become profitable, access funding (if necessary), and eventually, to sell.
In business, the most common type of risk analysis one can perform on a company is known as the SWOT analysis. QuickMBA defines a SWOT analysis as examining an organization’s Strengths, Weaknesses, Opportunities, and Threats. A firm’s strengths and weaknesses are determined by factors inside the company, whereas opportunities and threats refer to environmental factors (such as competition and alternatives) outside of the business. After fleshing out this analysis, you should have a better idea of the risk level of the company offering you the position.
You are even are justified in requesting to see some financial reports in order to judge the health of the organization. Run from any executives offering equity-based pay who have a problem showing candidates evidence of company financial success, as they likely have something to hide.
Has This Company Been Funded?
As part of your risk assessment of a company, determine whether the company has been funded. Funded companies are typically a safer bet than bootstrapped ventures for two important reasons. First and foremost, a funded company has more money to work and compete with. Developing a cutting edge product and marketing it effectively is not a cheap process, and having investors to make sure the bills get paid is a great asset for any new business to have.
Second, funding is a seal of approval from a professional investor. This is not to say that all funded companies are bound for success, however venture capitalists are trained to assess businesses by their strengths and weaknesses. If the company was funded, it mean that a professional evaluation was performed on every aspect of the start up and it was determined that they were likely to do well.
Sweat Equity Or Equity With Compensation?
The arrangement of pure equity without additional compensation is considered a fairly risky agreement. The potential pay-out could be quite large since you will likely be offered significant equity if no money is involved. However if the company does not succeed, or takes very long to start making money, you might squander years of time on a botched investment.
A less troublesome arrangement is that of equity with compensation. In this scenario, your expected salary is reduced and augmented with equity. Online start up resource GrowThink.com gives an example of this, stating that if your services are worth $80,000/year, you might be offered $60,000 in salary and $20,000 worth of equity.
Equity As a Performance Incentive
Equity pay can be an powerful motivating force for those working in areas that directly affect the revenue of the business. If your special skills and knowledge have an impact on the sales of goods or services, an equity stake with compensation (as discussed above) is sometimes preferable.
The harder your work the more your equity will be worth. At a certain point, your stock might be valued at far more than your full salary could have ever provided you.
Is The Equity Appropriate For Your Position?
Another way to sniff out a good deal is to see if the equity you are being offered is appropriate for your position. Exceptionally high offeres may be indicative of a hurting company looking to lure in a rescuer without having to pay them money.
Guy Kawasaki, a technology venture capitalist, compiled a list of typical equity amounts for common positions. These are:
- Senior engineer: 0.3% to 0.7%
- Mid-level engineer: 0.2% to 0.4%
- Product manager: 0.2% to 0.3%
- Head Architect: 1.0% to 1.5%
- Vice presidents: 1.5% to 3.0%
- Chief Executive Officer: 5.0% – 10%
If your equity offer falls within these figures, Kawasaki’s research would deem it a reasonable offer. This is not to say you shouldn’t still proceed with caution, however it does give you guidelines to help you spot unreasonable or suspicious requests.
Vested Equity
Before accepting an equity-based pay arrangement, you should determine if the equity is vested, or granted all up front. Vested equity is paid out in increments over time. If you are to receive a 2% equity stake vested over the course of four years, you might receive 0.5% per year along with your regular pay. GrowThink.com reports that this strategy is often used as an incentive to keep employees in their positions for that period of time, with the promise of more equity as a motivating factor to continue working hard.
In order to intensify this motivation, some companies have even taken to offering scaling equity, such that you earn progressively bigger stakes per year until you earn your total amount. Under this arrangement, a 4.5% stake vested over two years might be paid out as 0.5% in the first year, 1% in the second year, 1.2% in the third year, and 1.8% in the fourth year.
What Stage Are You At In Your Career?
Equity-based pay (especially full equity pay), must be considered in the context of your current career. If you are a young professional who has the time and energy to work lots of overtime hours to effectively grow your equity stake, this sort of pay arrangement might be best for you.
Conversely, those have already established themselves in their careers and earn strong salaries might have trouble taking a serious pay cut and working more hours for an equity share. Since equity is only a wise investment if you plan to put long, hard work into raising its value through your actions, these sort of arrangements are befitting of those seeking to establish their career and begin building wealth.
Equity Compensation – Pros, Cons, and Vesting Decisions
What’s the Deal with Equity Compensation?
Let’s say you have the cash you need to get things set up – but you’re hurting for cash flow (i.e. additional money coming in every month). This can make it pretty hard to pay your employees, particularly skilled marketers, programmers, and engineers who may rake in more than six figures a year at a more established company. Equity compensation is one way to get them on board.
The general idea of equity compensation is to offer employees a share of the company’s future profits in exchange for lower (or sometimes zero) salaries up front. Of course, as with equity financing, we highly recommend consulting a lawyer before making any formal offers.
THE PROS AND CONS
As with any form of compensation, there are pros and cons to offering equity compensation.
| THE PROS | THE CONS |
|---|---|
| Motivated Employees –Equity compensation not only lessens the up-front financial burden of paying out sky-high salaries, but it also attracts employees who are committed to working harder in order to ensure their financial wellbeing and the success of the company. | It’s Complicated – The most obvious con with equity compensation is that it requires giving up small portions of ownership of your business. This is decidedly more complicated to handle than a traditional salary – and when you’re starting a small business, more complicated is exactly what you DON’T need. |
TYPES OF EQUITY AND VESTING TERMS
If you decide that equity compensation is something you’d like to offer, then your next move should be to figure out exactly what type of equity to use.
Here are four major types of equity used by small businesses:
- Common Stock – a small portion of ownership in the business that pays dividends (a percentage of profits) when the company makes money.
- Preferred Stock – similar to common stock but dividends are paid FIRST to preferred stock holders, then to common stock holders. Preferred stock is essentially common stock with a “skip to the head of the line” guarantee.
- Issuing Shares – common stock that is given for free to employees (they don’t have to buy a share, you give it to them as a bonus or gift).
- Warrants – also known as “stock options,” warrants convey the right to purchase stock at a future date for a set price, determined at the time the warrant is issued. For example, a company might offer an employee the ability to purchase five shares of stock at $100 a share in five years. If in five years a share of the company is worth more than $500, the employee has the option to buy it at $100 a share and sell it the next day for $500 a share.
In addition to the different types of equity, there are also variations in vesting terms. Vesting terms are just a fancy way of saying how long an employee has to work for you before they can collect their equity benefits. Outlining a vesting term protects you from an employee that signs on, takes their cash the second the business turns a profit – and then high tails it outta there two months later.
If you have a business partner or co-founder, you can set up a vesting schedule to ensure you’ll both stay on board.
Most companies require about 12 months of employment before employee benefits (equity, 401k match, etc.) are fully vested – but of course, that’s up to you to decide!
Who Gets What and How Much
Now that you’ve decided what type of equity you’re going to offer to your employees, it’s time to figure out how much they’re going to get.
If you offer too little, they might say sayonara and take a job where they get paid cold hard cash. Offer too much – and down the road your employees end up making more money than you. Not good.
The first decision you need to make is whether to offer your employees 100% equity compensation or a combination of salary and equity. On the plus side, offering employees equity alone means you’ll end up with employees who truly believe in your business and are willing to work hard to see it succeed. On the other hand, it may eliminate qualified employees who simply cannot survive without some cash flow during the time it takes to make the business profitable.
Once you’ve sorted out the percentage of equity vs. salary, it’s time to negotiate the amount of equity. While there are no specific guidelines as to how much equity each type of employee should receive (every business is different) there are a couple things you should consider.
- The amount the employee will receive in salary pay (and how much lower it is than a typical salary for an equivalent position).
- The employee’s predicted impact on the success of the company.
Ideally, you’re able to calculate (approximately) the amount the employee is worth to the company, and offer them an amount of equity that is equal to their worth – based on your predicted profits in 12 months.
Getting Paid in Equity: Help for Employees
Ok, so if you’re not a small business owner looking at equity programs, you’re probably an employee who’s been offered some to sweeten the pot. But is the equity the startup offered you actually a good deal?
Equity-based pay is often used by the founders of young startups who want to grow their businesses but cannot offer big salaries to qualified professionals. Typical arrangements seek to either partially or fully compensate service providers with stock in the company in exchange for hard work.
Depending on where you are at (career- and age-wise), as well as where the company is at –and where it is going– this offer could either be an amazing opportunity, or it could be a total waste of your time and potential.
Below are some helpful tips and suggestions to keep in mind when contemplating whether or not to take an equity-based position.
Gauge The Company’s Ability To Sell
Equity compensation can be a lucrative investment of your time if you work for the right business. When deciding whether to accept such an offer, you must perform a sort of risk assessment of the company, including their ability to become profitable, access funding (if necessary), and eventually, to sell.
In business, the most common type of risk analysis one can perform on a company is known as the SWOT analysis. QuickMBA defines a SWOT analysis as examining an organization’s Strengths, Weaknesses, Opportunities, and Threats. A firm’s strengths and weaknesses are determined by factors inside the company, whereas opportunities and threats refer to environmental factors (such as competition and alternatives) outside of the business. After fleshing out this analysis, you should have a better idea of the risk level of the company offering you the position.
You are even are justified in requesting to see some financial reports in order to judge the health of the organization. Run from any executives offering equity-based pay who have a problem showing candidates evidence of company financial success, as they likely have something to hide.
HAS THIS COMPANY BEEN FUNDED?
As part of your risk assessment of a company, determine whether the company has been funded. Funded companies are typically a safer bet than bootstrapped ventures for two important reasons. First and foremost, a funded company has more money to work and compete with. Developing a cutting edge product and marketing it effectively is not a cheap process, and having investors to make sure the bills get paid is a great asset for any new business to have.
Second, funding is a seal of approval from a professional investor. This is not to say that all funded companies are bound for success, however venture capitalists are trained to assess businesses by their strengths and weaknesses. If the company was funded, it means that a professional evaluation was performed on every aspect of the startup and it was determined that they were likely to do well.
SWEAT EQUITY OR EQUITY WITH COMPENSATION?
The arrangement of pure equity without additional compensation is considered a fairly risky agreement. The potential pay-out could be quite large since you will likely be offered significant equity if no money is involved. However if the company does not succeed, or takes very long to start making money, you might squander years of time on a botched investment.
A less troublesome arrangement is that of equity with compensation. In this scenario, your expected salary is reduced and augmented with equity. Online start up resource GrowThink.com gives an example of this, stating that if your services are worth $80,000/year, you might be offered $60,000 in salary and $20,000 worth of equity.
EQUITY AS A PERFORMANCE INCENTIVE
Equity pay can be a powerful motivating force for those working in areas that directly affect the revenue of the business. If your special skills and knowledge have an impact on the sales of goods or services, an equity stake with compensation (as discussed above) is sometimes preferable.
The harder your work the more your equity will be worth. At a certain point, your stock might be valued at far more than your full salary could have ever provided you.
- WANT TO KNOW MORE?
- Negotiating Your Startup Job Offer — Rob.by.
- You’ve been offered shares. Now what? — Reuters
IS THE EQUITY APPROPRIATE FOR YOUR POSITION?
Another way to sniff out a good deal is to see if the equity you are being offered is appropriate for your position. Exceptionally high offers may be indicative of a hurting company looking to lure in a rescuer without having to pay them money.
Guy Kawasaki, a technology venture capitalist, compiled a list of typical equity amounts for common positions. These are:
- Senior engineer: 0.3% to 0.7%
- Mid-level engineer: 0.2% to 0.4%
- Head Architect: 1.0% to 1.5%
- Vice presidents: 1.5% to 3.0%
- Chief Executive Officer: 5.0% to 10%
If your equity offer falls within these figures, Kawasaki’s research would deem it a reasonable offer. This is not to say you shouldn’t still proceed with caution, however it does give you guidelines to help you spot unreasonable or suspicious requests.
VESTED EQUITY
Before accepting an equity-based pay arrangement, you should determine if the equity is vested, or granted all up front. Vested equity is paid out in increments over time. If you are to receive a 2% equity stake vested over the course of four years, you might receive 0.5% per year along with your regular pay. GrowThink.com reports that this strategy is often used as an incentive to keep employees in their positions for that period of time, with the promise of more equity as a motivating factor to continue working hard.
In order to intensify this motivation, some companies have even taken to offering scaling equity, such that you earn progressively bigger stakes per year until you earn your total amount. Under this arrangement, a 4.5% stake vested over two years might be paid out as 0.5% in the first year, 1% in the second year, 1.2% in the third year, and 1.8% in the fourth year.
WHAT STAGE ARE YOU AT IN YOUR CAREER?
Equity-based pay (especially full equity pay), must be considered in the context of your current career. If you are a young professional who has the time and energy to work lots of overtime hours to effectively grow your equity stake, this sort of pay arrangement might be best for you.
Conversely, those have already established themselves in their careers and earn strong salaries might have trouble taking a serious pay cut and working more hours for an equity share. Since equity is only a wise investment if you plan to put long, hard work into raising its value through your actions, these sort of arrangements are befitting of those seeking to establish their career and begin building wealth.
Business Equity for Entrepreneurs
Is Equity Even For Me?
The How-tos of Equity Financing
The How-tos of Equity Compensation
- The pros and cons of equity compensation
- Types of equity compensation and vesting terms
- How much equity you should offer your employee
Getting Paid in Equity: Help for Employees
- Gauge the company’s ability to sell
- Sweat equity or equity compensation?
- Is the equity appropriate for your position?
Equity Resources for Your Business
- How to calculate equity
- Resources to help you on your journey
- Resources for employees considering equity
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