Equity compensation: How types work, pros and cons

What is equity compensation?

Equity compensation is a type of non-cash compensation where employees earn an ownership stake in the company they work for. Ownership may take the form of stock options (including virtual stock options), restricted stock units, and employee stock purchase plans (ESPPs) that allow workers to purchase company stock at a discounted rate.  

The value of equity compensation is tied to the company’s performance. When the company does well and meets its targets, the value of the ownership increases, and vice versa. 

Common types of equity compensation 

Some of the most common types of equity compensation include:

• Stock Options: Employees have the option—but not the obligation—to purchase shares of the company stock at a predetermined price.
• Employee Stock Purchase Plan (ESPP): Employees can opt to purchase company stock at a discount price at set intervals via a payroll deduction. These plans often have tax advantages.
• Virtual or Phantom Stock: Employees purchase portions of shares of the company and receive a payout of their value at a predetermined point, but don’t actually have any ownership of the company or the rights and privileges of a shareholder.
• Series B Equity Compensation: These options are awarded after a startup has completed its Series A funding, started acting on its business model and strategy, and demonstrated that its strategy is working. Funding may come from the initial investors or a new set of Series B investors.    
• Restricted Stock: This form of equity compensation is relatively rare. Essentially, it’s stock granted in the very early stages of a company to entice talent or investors, but there’s usually little or no market for it. Restricted stocks have limited value and significant tax implications, so they tend to be a good faith promise to individuals to stay with the company in the early stages. 

Benefits of equity compensation

Offering equity compensation benefits both employers and employees in several key ways.

1. Manage cash flow

For many smaller companies and startups, equity compensation is an attractive means of managing cash flow while still offering talent competitive compensation. When a company has limited cash on hand, attracting the best people can be challenging, but deferring compensation can solve that issue. In some cases, equity compensation programs make companies eligible for tax credits, which also helps with cash flow. 

2. Increase employee engagement

Because the value of the equity compensation is based on company performance, employees who participate in these plans have a greater incentive to take ownership of their work and commit to achieving their goals. Employees are encouraged to “act like owners” and go the extra mile toward helping the company achieve success. 

3. Attract and retain top talent

Providing the opportunity for employees to share in the company’s success encourages them to join the organization and stay there. People want recognition for their efforts, and providing the chance for them to build their wealth as the company grows is an effective method of doing that. 

4. Encourage loyalty

Most equity compensation plans require employees to fulfill specific conditions, such as hitting performance targets or staying employed with the company for a minimum period of time before becoming vested or fully eligible to take complete ownership of their shares in the company.

Drawbacks of equity compensation 

While equity compensation is an attractive option for many companies and employees, it does have some drawbacks that need to be considered. 

1. Misaligned priorities

Although equity compensation has the potential to increase worker commitment to the company’s goals and give them a greater stake in the organization’s overall success, there’s a possibility that the program may have the opposite effect. Employees may not be willing to take as much risk or wait as long for returns as shareholders. This can lead them to prioritize short-term gains over the company’s long-term success, creating tensions and misaligned interests.

2. Dilution of ownership

Offering all employees the option to own company shares can reduce the value of individual shares and the earnings per share. It can also reduce the control that existing or long-term shareholders have over the company.

3. Limited appeal

Equity compensation plans aren’t necessarily appealing to all employees. Although typically a welcome benefit in the C-suite, where employees earn higher salaries, other employees may not find the option as valuable and prefer cash over equity compensation. Earning benefits on paper may have a detrimental effect on employee satisfaction and engagement.

4. Accounting complexity

Managing an equity compensation plan is complex and can create some accounting challenges for companies. The value of stock options can affect company financial statements and ratios, effectively making it look like the company has more liabilities than it actually does, which can affect investor perceptions.