Compensation through Equity: Definition, Classes, Advantages, and Disadvantages

Equity compensation, also known as stock-based compensation, is a form of non-cash pay that provides an ownership stake in a company. This type of compensation can take various forms, each with its unique features and benefits.

Nonqualified Deferred Compensation Plans (NDCPs)

NDCPs allow employees to postpone income (salary, bonus, or other eligible cash payments) to a later date. This arrangement helps employees target specific future goals and puts taxes off until a later time, as the income grows tax-deferred within the plan.

It is essential to note that NDCPs are not equity-based compensation plans but can be offered alongside other forms of equity compensation, particularly to key employees.

Phantom Stock

Phantom stock is a contract that mimics the perks of stock ownership without actually receiving company shares. This arrangement can be beneficial for employees who want to share in the company's success without the responsibilities that come with actual stock ownership.

Stock Options

Stock options give the right to buy a certain number of company shares at a set price during a specified period. The specific conditions for receiving stock options at a given company generally include a vesting period and contractual rules that may specify how options may lapse, especially upon leaving the company.

Employee Stock Purchase Plans (ESPPs)

ESPPs provide employees with the opportunity to purchase shares of company stock at a discount. This type of equity compensation can be an attractive option for employees who believe in the long-term growth potential of their company.

Stock Appreciation Rights (SARs)

SARs give the right to the monetary equivalent of the appreciated value of a company's share price. This type of equity compensation is different from stock options, as it does not give the right to purchase shares but rather provides a cash payment based on the increase in the share price.

Restricted Stock Units (RSUs) and Restricted Stock Awards (RSAs)

RSUs are a company's promise to grant a certain number of shares upon vesting. RSAs, on the other hand, are company shares doled out on the grant date. RSUs differ from RSAs in that the shares are granted at a later date based on vesting schedules.

Performance Shares

Performance shares are awarded when specific performance-related goals are met. This type of equity compensation is designed to align the employee's incentives with the company's overall performance.

Attracting Top Talent

Offering equity compensation can help employers attract top talent. The potential for a hefty payout is appealing, especially for employees who believe in the long-term growth potential of the company. Moreover, having a stake in the company may help to align the employee's incentives with that of the employer, potentially increasing productivity and commitment to the company for the longer term.

Tax Considerations

Companies that offer equity compensation may earn a tax credit, minimizing their federal tax liability. However, employees should seek a second opinion from a financial advisor well-versed in equity compensation to ensure all relevant nuances are considered when devising a plan of action.

Cash Flow Management

Companies, particularly smaller companies and startups that may have limited cash on hand to attract top talent, may offer equity compensation in place of a high salary to help manage their cash flow.

In conclusion, equity compensation offers employees a unique opportunity to share in the success of their company and align their interests with those of the employer. It is essential for employees to understand the different types of equity compensation available and how they work to make informed decisions about their financial future.

Compensation through Equity: Definition, Classes, Advantages, and Disadvantages