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Equity Compensation: What Is It and How It Is Used

by / ⠀Career Advice / June 15, 2022
compensation

Oftentimes, private companies, including those fiercely protected or family-owned, find it difficult to locate and retain important management personnel. Because a lot of the time poaching by other competitors happens through total compensation packages. Now while the equity of private companies cannot be traded via a stock exchange, it also might not be marketable.

But, multiple means exist by which a private company can provide incentives relating to equity to employees. Much of this contains long-term and liquid investments to get those employees to stay.

A major, if not main, concern for a private company is the thought of giving up control and letting minority shareholders have a say in the business. But, through equity compensation, these businesses can give these shareholders long-term equity incentives without giving up control of the company.

So, what is equity compensation?

The Benefits of Equity Compensation

Public-held businesses often have three main compensation ingredients: annual bonus, salary, and long-term equity compensation such as stock options. However, a private and smaller business will find it difficult to recruit high-level management as these private businesses don’t usually offer long-term equity compensation.

But, if they do offer equity compensation, a private company offers:

  1. An incentive for employees to do their best at the company.
  2. The company can save by paying lower cash compensation.
  3. The company can compete with its competitors by offering equity.

Types of Equity Compensation

Stock Options: This allows employees the right to purchase equity in the company at a predetermined price. This is beneficial to the employee as the options allow the employee to benefit from an increase in the value of the company.

Restricted Stock Awards: A grant of stock potentially forfeited if priority conditions are not met in time. But, as a benefit, it provides an incentive to the worker and helps with retention.

Equity Bonus: Paid through equity rather than cash. Given out for performance. Once again, it provides an incentive to meet goals while also minimizing cash outlays from the company.

Stock Purchase Plans: This allows employees to purchase equity from the company but at a discount. Provides incentive by allowing the employee to participate in growing the company and giving the company liquidity at the same time.

Stock Appreciation Rights (SARs): Companies give cash or stock in the same amount to the fair value of the equity from the company to employees. But, it needs completed on the date of the exercise and over the price—usually equal to the fair value of the equity. Employees would be given the same financial gains as a comparable stock option, but without requiring cash outlays. SARs do not give up control of the company if settled in cash.

Phantom Stock Units: Employees receive stock or cash equal to value upon the time of a predetermined event such as retirement or the change of control of the company. For benefits, the phantom stock units are given something similar to SARs, but the value is tied to the event of an employee’s election.

The Concerns of the Employer

When it comes to providing equity to employees, there are several concerns of the employer.

  1. Dilution of the current owners and reduce their ownership of the company.
  2. Make sure that the equity is not transferred to a third party not affiliated with the company
  3. Value of a secret that is not of public trade
  4. Funding repurchases of shares from the company

Issues Regarding Accounting, Legal, and Tax

Depending on the equity incentive as well as the type of payments, a variety of laws that relate to accounting, legality, and taxes influence individuals offered the incentives. Speak to advisors well-versed in corporate laws. This helps ensure that you do everything correctly in the eyes of the law.

Private companies have to comply with the security laws of their state. Also known as “blue sky” laws, they require registration of security or finding exemptions. Typically this research completes when the residence determined for every worker expected an offer of security.

Companies also consider different kinds of corporate laws to ensure that the equity dispenses to individuals correctly. Tax treatment can vary depending on the employee and company. But, tax treatment also depends on the actions of elections completed by the employees.

With accounting, that all depends on the company itself, as accounting is beyond the scope of this article and to the knowledge of the writer. However, possibly treat equity as an expense in the income statement. That will cause it to reduce earnings. The company must consult with the accountants before having an equity award program so that the company can meet the standards that come with the award system.

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About The Author

Tristan Anderson

Hello! My name is Tristan Anderson and I live in Manhattan, Kansas. I enjoy being in nature and animals. I am also a huge geek who loves Star Wars and has a growing collection.

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