What Is Employee Equity? A Definitive Guide
Updated June 9, 2023
Many companies look for a diversified strategy when compensating employees and attracting new talent. Some companies, such as start-ups or public companies, may use employee equity plans as a means of increasing their compensation packages without using their cash reserves. Learning more about this type of allowance can increase your ability to find and keep quality employees. In this article, we discuss employee equity, including its various types and value, and review answers to FAQs about this type of compensation.
What is employee equity?
Employee equity is a form of noncash compensation that provides a share of the company's ownership. Employers can offer it to an employee, a board member, a consultant or anyone as performance shares, options or restricted stocks. Employee equity can be a helpful means of attracting and retaining work talent, especially during the early stages of a business. In addition, employees receive a share of the company's profit, which can encourage them to put in extra effort toward its success.
Employee equity is usually accompanied by a vesting period and can sometime make up for a lower salary. The vesting period is the amount of time an employee must work for the company before they have a nonforfeitable right to their stock or asset. The founders determine the size of the equity pool of a company, which is the number of reserved shares from which the company can issue restricted stock options. Typically, it's between 10% to 15%, but this can vary depending on the company and the level of involvement of the founders.
Related: How To Negotiate Equity in 9 Steps
4 types of employee equity
Here are four common types of employee equity:
1. Employee stock option
Employee stock options are a common type of employee ownership, given as part of an employee stock ownership plan (ESOP). Stock options are susceptible to vesting, which is the process of awarding stock or stock options over a certain period of employment. After meeting these terms, employees can choose these options to get shares by paying the stated exercise price.
To the benefit of employees, even if the stock price rises, they may still buy it at the strike price, which is often much cheaper than the market price. After that point, an employee can sell the stock for a profit. However, unlike stock grants, each employee has to buy shares to gain ownership.
2. Restricted stock
This type of employee equity is often issued to senior leaders in the organization, such as executives and directors. These stocks often have restrictions, such as a vesting term, including length of employment or performance goals. They're used as a form of executive compensation or during mergers or affiliate ownership. If an executive leaves the company, they usually relinquish rights to this stock.
3. Restricted stock units
Restricted stock units, or RSUs, are promises made by an employer to grant an employee a certain amount of stock at a determined future date. Employees can obtain these shares after the vesting period, but only if certain requirements are satisfied. Employees become a stakeholder under this plan once they meet this criterion. Because of the tax ramifications, founders are shifting toward this style of stock distribution.
4. Virtual stock
Virtual stocks are stocks used by businesses as a kind of long-term deferred remuneration. Because the stock does not technically exist, it may be a useful workaround for organizations and employees who would rather avoid the tax and administrative paperwork that come with granting ownership. In this case, the corporation does not issue the employee any actual stock options. Instead, the employee's partial payment value is calculated using company shares as the benchmark. As a result, it does not make an employee a valid owner.
However, it can be an excellent method to reward essential workers with stock while maintaining a high level of control over your company. Because the firm credits these virtual shares to its books, the value of the virtual stock grows and falls with the value of the company's shares. After the vesting period, employees can receive their virtual stock in form of cash or comparable quarterly or yearly bonuses.
What are the company benefits of using employee equity?
Employee equity gives each employee a personal interest in the firm. Employee equity, even more than salary, may provide greater motivation for improving personal performance. If the employee can increase the success of the company, they can help increase its profits and thereby improve their stock. And by attaching vesting periods to the equity, a company can increase the longevity of their employees.
Employee equity can also attract high-value candidates to a company. Rather than offering a simple salary, a company can allow these professionals to earn more by attaching their performance to the company's success. Both the company and the individual can benefit from their personal qualifications and motivation to succeed.
Employee equity vs. team equity
Team equity is how the founders of a company split the percentages of a startup's initial ownership. These divisions usually add up to full ownership, except when a few stocks are set aside for employee equity. Several factors may influence the division of team equity, including idea ownership, investment amount and time dedication. A division may be even among owners or weighed by these factors.
Employee and team equity both entail the distribution of company stock. While team equity refers to the ownership portion of a firm's founders, employee equity does not always involve the company's founders. Instead, the founders' ownership during its early stages grants employee equity.
FAQ about employee equity
Here are some frequently asked questions about employee equity:
Can you negotiate equity compensation?
Similar to other forms of compensation and benefits, people are allowed to negotiate equity. It may be beneficial to review your personal needs and research equity options before arranging terms with your potential employer. When negotiating, you can refuse equity and ask for a larger base salary instead or a small compensation with larger percentage ownership and a shorter vesting period.
Does accepting equity as compensation require a lower salary?
Sometimes, as part of a comprehensive pay package, a company may grant a significant ownership that results in lower salary. However, this isn't always the case. Some corporations include stock options as part of an excellent salary package. The stock is used to recruit talent and improve prospective profitability. It's crucial to look into the stock options given by your future company and compare your basic wage to state or national norms.
When can you cash out equity compensation?
When your stock vests, you receive complete ownership of the stock. However, the length of your vesting period depends on the personal arrangement you make with your company. When you complete this period, you may cash out by selling your share to your employer.
Does company equity come with tax liability?
Typically, uninvested equity has no tax implications. However, vested equity incurs tax in some circumstances, depending on what you do with your partial business ownership. It's taxable, for example, if you cash out or sell your stock or if you receive dividends or any other type of income from your equity.
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