Understanding the Purpose of Equity Pay

Employees receive equity pay instead of cash, which can take various forms such as stock options, restricted stock, and performance shares. These forms of compensation act like investments, turning employees into part-owners of the company.

With equity pay, employees can benefit when the company performs well, and it incentivizes them to stay with the company, especially if there are certain conditions they need to meet before fully owning the equity. However, when employees receive equity pay, their actual salary may sometimes be lower than the standard market rate.

Breaking Down Equity Pay

Equity pay is a benefit offered by many public and some private companies, particularly startups. These companies may not have a lot of money at the beginning or may prefer to invest their funds in growing the business. So, instead of cash, they offer equity pay to attract talented employees. This practice is especially common in technology companies, whether they're just starting or are already well-established.

However, getting equity pay doesn't guarantee that you'll make money. Unlike a fixed salary, where your payment is known, equity pay depends on various factors. There's no certainty that it will translate into financial gain for you.

Explaining Equity Payouts

Companies distribute equity pay in various ways, through vested equity and granted stock. Vested equity involves stock options or shares that employees earn over set periods according to a vesting schedule in a contract. On the other hand, granted stock, such as restricted stock units (RSUs), is given upfront but typically still follows a vesting schedule. Although receiving equity can be a substantial offer, it comes with the risk of choosing it over or alongside a salary. The value of the equity depends on the company's performance and market conditions.

Understanding the structure of an agreement and the type of equity offered is crucial. Sometimes, a company may not offer direct equity but instead provide options to buy equity. These options could belong to a different equity class than that of the founders.

Some plans require employees to quickly decide if they want to buy company shares when they leave the company. This can be challenging because they may not know if the company will succeed or if the shares will appreciate in value.

Offering lower salaries and unfavorable equity terms is not a good strategy for attracting top talent. Here are some fair equity plan options:

• The company purchases the options for the employee, taking on the risk. This approach saves the employee from bearing the cost.
• The company loans the employee the money to buy the options. Repayment upon liquidation.
• The company extends the option period to 10 years. This allows the employee to hold the options and see if their value increases.

These solutions help new employees by giving them more time to decide about stock options without having to pay upfront. But in tough negotiations, job seekers should be in control. They can choose to leave or get assistance from an agent or legal support.

If a company is unwilling to find middle ground, it may reflect how they treat employees. This could mean they have a strict culture or suggest that they are taking advantage of people. Wise business owners know that having fair and clear job agreements is crucial for keeping good employees. If employees think a deal is unfair, they should consult experts for advice, especially since stock agreements can be complicated.

Illustrating Equity Pay vs. Salary

When your company gives you stock options, it means you could get a big reward if the company performs well. You could even become wealthy if the company successfully goes public, as was the case for early employees at companies like Google (GOOG) and Meta (META), who became millionaires. In contrast, if you're only earning a salary, there's no potential for a big payout down the road. Any additional returns would come from investing your income independently.

However, there's a catch with equity pay—taxes. Even if your share price drops after you exercise your options and own the shares, you may still owe taxes. This adds another layer of risk. Timing is also crucial; you need to exercise your options at the right moment and strategically sell your shares to generate an actual return, not just a theoretical one on paper.

It's important to understand that different forms of compensation come with varying tax consequences. Understanding how your employer structures your equity pay is essential, as it can significantly impact your eventual payout, depending on the type of compensation and the size of your stake in the company. On the other hand, salary payments don't involve this level of complex structuring, except perhaps when negotiating the timing of any bonus payout for tax-planning purposes.

Types of Equity Pay

• Stock Options

When companies provide equity pay, they may offer stock options to employees. This means employees get the right to buy company stocks at a set price, known as the exercise price. Over time, this right becomes fully available, encouraging employees to stay with the company. Once the option vests, employees can sell or transfer it. However, it's important to know that these options usually have an expiration date.

It's important to mention that even though employees with stock options aren't considered as stockholders and don't have the same rights, there are distinct tax rules for vested and non-vested options. Employees should understand the tax implications based on their individual situations.

• Non-Qualified Stock Options and Incentive Stock Options

Other types of equity pay include non-qualified stock options (NSOs) and incentive stock options (ISOs). ISOs, available only to employees, come with special tax advantages. For example, employers don't need to report when employees receive or exercise NSOs.

• Restricted Stock

Restricted stock involves a vesting period, which can happen all at once or gradually over several years. Restricted stock units (RSUs) work similarly, with the company promising to provide shares according to a vesting schedule. While this benefits the company, employees don't have ownership rights, like voting, until they've earned and received the shares.

• Performance Shares

Companies grant performance shares based on achieving specific measures, such as meeting earnings targets, return on equity, or stock performance compared to an index. These awards usually extend over multiple years.

Conclusion

Employees receive equity pay, a form of non-cash payment. This payment includes stock options, restricted stock, and performance shares, all of which indicate ownership in the company. Sometimes, companies offer equity pay along with a salary below the market average. This benefit is commonly provided by many public and some private companies, particularly startups. It allows employees to have a stake in the company’s ownership.