A Business Owner’s Guide to Equity Compensation

A Business Owner’s Guide to Equity Compensation

December 01, 2023

As a business owner, understanding the various strategies for rewarding and incentivizing your employees is vital for employee retention and business growth. One strategy is equity compensation, which may be valuable when used appropriately for your business's situation.

Equity compensation is a non-cash remuneration through which employees receive a form of ownership interest in the company. This method benefits employees directly as the company's value increases. For example, startups and growing businesses are often cash-poor and unable to provide high monetary compensation. Equity compensation helps attract top talent, motivate performance, and align employees' interests with the company's strategic objectives.

Types of Equity Compensation

  1. Stock Options- a contract that grants employees the right (but not the obligation) to purchase company shares at a predetermined price. Two main kinds of stock options exist, with the main difference being in their tax treatment:
  • Incentive Stock Options (ISOs)- gives an employee the right to buy shares of company stock at a discounted price with possible tax breaks on the profit.
  • Non-Qualified Stock Options (NSOs)- The employee can buy shares at a discounted price and then pay ordinary income tax on the difference between the grant price and the option's stock price.
  1. Restricted Stock Units (RSUs) - a promise from the company to grant shares of stock or the cash equivalent at a future date once specified conditions are met, like a certain period of service or performance goals.
  2. Stock Appreciation Rights (SARs) - are rights given to employees to receive the appreciation of company shares. They hold similarities to stock options while excluding employees needing to purchase the shares to realize a gain.
  3. Employee Stock Purchase Plans (ESPPs) - permit employees to purchase company shares at a discounted price.

Once a business owner understands equity compensation and its various types, it is crucial to establish a detailed equity compensation plan by working with legal, financial, and tax professionals. Below are some steps to help guide business owners as they consider an equity compensation plan:

Step #1 - Determine the Objective. Clearly define your plan's goal: attracting and retaining, motivating, or aligning employee expectations with business objectives.

Step #2 - Decide the Type of Equity. From the above-listed options, choose the appropriate type for your company's goals and the employee's position. For instance, RSUs might be suitable for higher-level executives, while ESPPs could be suitable for general employees.

Step #3 - Establish the Terms. The term must include defining vesting schedules, setting the exercise price (for options), indicating the event(s) that can lead to the lapse of restrictions, etc.

Step #4- Communicate the Plan. Once finalized, communicate the plan clearly to your employees. It is crucial that they fully comprehend their equity compensation packages, their potential benefits, and associated risks.

Equity compensation can be a suitable strategy for a company to reward, motivate, and retain its employees. These plans can be appropriate to help employees benefit financially from the company's confidence, and business owners can drive their company's growth by aligning the interests of the business and its employees.

Drafting an equity compensation plan can be complicated and requires professional advice to execute it. Therefore, business owners must seek advice from legal, financial, and tax professionals or compensation consultants to help ensure the most suitable compensation plan for the business and its employees.

 

Important Disclosures:

This material was created for educational and informational purposes only and is not intended as tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.

This article was prepared by Fresh Finance.

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