What is Equity Compensation?
Cash strapped startups often look for ways to cut down their bottom line. When you’re still in your pre seed stage, every single cost saved is more you can reinvest in your startup and grow quicker. But what is equity as compensation, and why do so many startups turn to it as an option?
Well, equity compensation can actually serve as an add on alongside an employee’s salary. Your employees can accept a lower salary in combination with equity compensation, so that you can work together to grow your startup.
Sounds confusing, right? Let’s break it down.
What is equity compensation?
For employees, it’s a chance to earn much more when the startup goes big. For the employer, it’s an easy way to cut some expenses when they need them most.
However, not all equity compensation is the same. There's a
broad range of different varieties depending upon the type of startup.
Salary vs equity
Salary is the bog standard practice of the business world.
Employees work a set number of hours (ignoring overtime) in return for a stable, fixed monthly salary. In this way the startup can increase the accuracy of its financial forecasting because it knows exactly how much its spending on payroll every single month.
For employees, they understand exactly how much they’re getting on payday and can plan their month’s expenses as well - whether it’s organising rent or deciding between the expensive wine or the 3 bottles for £12 from Tesco.
With equity compensation, it’s slightly different.
Startups generally offer lower salaries alongside equity
compensation as an alternative to high end salaries. It can include
options, restricted stock and performance shares. Established companies
can also offer these options as well, especially when a star performing
employee has reached their maximum salary, but deserves to be recognised
in some way.
Types of equity compensation
There are 5 types of equity compensation with different advantages depending upon the business in question.
1. Stock options
Incentive Stock Options (ISOs) & Non Qualified Stock Options (NSOs)
Stock options are a great way to incentivise employees by offering them the right, but not the obligation to buy company shares.
The key is that these shares are bought at an exercise price (initially agreed price) after a vesting period.
A vesting period means that employees must perform well during the
vesting period and earn full ownership of these stock options. ISOs are
only taxed when they are sold, whereas NSOs can be taxed when you
exercise and sell them.
2. Restricted Stock
Restricted Stock Units (RSUs) & Restricted Stock Awards (RSAs)
Restricted Stock is an easier form of equity compensation. With less risk involved, employees earn their restricted stock after the vesting requirements have been met.
Employees may need to pay for the grants under RSA plans,
but they also gain voting rights and company shares immediately. With
RSUs the employee pays nothing for the grants, but also must fulfil the
vesting requirements before they may take full stock ownership of their
shares. RSUs must also pay full income tax including shares, whereas
RSAs may take advantage of section 83b to lower income tax.
3. Cash Deferred Bonus Plans
Sars & Phantom Stock
Deferred bonuses are equity compensation that doesn’t use stock shares, but instead rewards holders based on the company’s stock performance.
Now there is a vesting period for deferred bonuses, and the award will be determined based on the appreciation of the stock’s value, rather than the stock itself. After the vesting period is complete, employees will either receive a cash equivalent, or the stock itself.
Aside from the tax paid on the cash bonus, employees pay
nothing towards the stock itself, and the company avoids dilution of
ownership as long as they pay the cash bonus.
4. Performance Shares
These are the business version of “do your chores and you’ll get your pocket money!” Performance shares are issued under the vesting requirements of certain goals or aims.
While primarily directed towards executives and directors,
these performance shares have no set limits or guidelines. They can be
based on strategic, financial or growth goals.
5. Employee Stock Purchase Plans (ESPPs)
ESPPs offer employees the chance to purchase stock at cheaper rates than otherwise possible. The company offers employees a discount of between 5-15% below fair market value (FMV) and deducts the costs from an employee’s paycheck over time.
Once an employee has paid the entire price of their stock
share at the discounted price, they then gain control of their stock on
the purchase date.
Want to learn more about a tax advantaged share option scheme?
The benefits of equity as compensation for employers
There's a vast range of advantages for employers to offering equity compensation. It can:
Improve cashflow management
For startups looking to reduce their outflow of expenses, with equity compensation you can offer incentives without the cash loss.
Attract & retain talent
You may not have the cash on hand to dazzle talented
employees. However, by offering adequate equity compensation you can
more than make up for it and retain them for the vesting period of
Employees working for equity compensation will likely do far more than the bare minimum. They’re tied up in your business and understand that the harder they work, the greater the success and the bigger payoff from their stock shares.
Builds a team
Your employees are now employee owners. It builds team
spirit across your business as they now have a voice through shareholder
The benefits of equity as compensation for employees
Equity compensation can provide a convenient, long term investment for many employees. It can offer decent payoffs in the future, or for those more entrepreneurial employees - a chance to buy, sell and trade shares.
But of course, there is one enormous reason why equity compensation is so good for employees - it has made millionaires.
When a successful business goes public, it can change the
lives of its employees in an instant. Just look at Google and Meta -
their employee shareholders became millionaires overnight. That is the
true value of equity compensation for employees.
Drawbacks of equity compensation
For employees, there’s always the chance that a business will go bust. If you’ve invested more than a reasonable amount in a company and they go bust, well, so too do your shares. That’s the only way that equity compensation becomes a drawback.
For businesses, especially eager startups, the danger is that you dilute ownership too much. By selling more equity than you should, you can endanger the future of your business. On top of that, the taxes surrounding equity compensation should not be taken lightly.
In short, it takes a tremendous amount of prudent financial
planning from seasoned experts to not only create a viable shareholder
model. But to execute it with intelligent and accurate reporting to
manage your taxes.
How to safely execute equity as compensation
You wouldn’t let a doctor dictate your finances. They do what they do best - save lives. You do what you do best - run your business.
Which is why for finances you need a finance expert.
We are the #1 finance partner for Startups. Our selection of accountancy services offer flexible, yet comprehensive cover for all of your Startup needs. With a dedicated CFO service on hand, you can receive the top-tier financial planning you need to execute equity compensation and handle the taxes involved, without the costs of maintaining one in-house.
It doesn’t stop there, our R&D Tax Credit service can get you much needed tax relief and lower corporation tax, while our advanced bookkeeping software manages your books and payroll so that you don’t have to.