The general tenet when it comes to providing employee compensation is “cash is king.” But, to attract top talent while staying within their budgetary constraints, startups must be creative in their approach to compensation. One well-liked and alluring alternative approach is equity compensation.
What is compensation for equity?
Increasing equity compensation is one way to increase a company’s cash flow. The employee receives a portion of the company as compensation rather than a salary. There are conditions attached to equity compensation, and initially, there is no return for the employee.
Startups frequently use the prospect of equity to entice top talent. Why? Many startups lack capital, but they can still offer equity because they can issue shares whenever they want. The company benefits greatly from this arrangement because it avoids having to pay salaries, which could negatively impact the company’s initial cash flow.
Let’s take the scenario where you appoint a chief technology officer. Even though you may give them a salary that is 35% less than the market rate, you also give them some equity to make up for it.
How are dividends on equity distributed?
Every business distributes equity uniquely. Vested equity and granted stock are the two primary categories of equity. Payments for vested equity are made over a specified number of installments as specified in a contract. Given stock is given out at the start of a contract. The employee accepts the risk of accepting equity instead of, or in addition to, a salary, even though the equity offer may be substantial.
The advantages of equity compensation
Equity compensation offers a flexible and financially advantageous option for businesses, especially those with limited salary reserves. It also presents an appealing business opportunity for employees, thus benefiting both parties.
Benefits for employers
Employers can reap numerous financial advantages by providing equity compensation to their workforce. These benefits include improved cash flow, tax savings that provide greater business flexibility, and a more contented and productive workforce that enables goals to be in line with the company’s objectives.
Companies will probably discover that employees who accept equity compensation put in more effort because they are driven by the knowledge that their income is dependent on the success of the business.
Benefits for workers
A variety of advantages are available to workers who receive equity compensation because, in the long run, their shares may be worth more than a regular salary or cash bonus. Furthermore, having stock in the company diversifies employees’ investment portfolios and increases their sense of commitment to the organization, which is an added motivator to put in extra effort.
The drawbacks of receiving equity pay
While there are many advantages to equity compensation for both employers and employees, there are also some drawbacks that employers should be aware of.
Drawbacks for employers
Employers who provide equity compensation must abide by all legal requirements, including tax laws and jurisdictional requirements, as well as all reporting requirements and regulatory standards. However, because these departments have to handle things like updating records, revising policies, and keeping track of ownership changes, the administrative burden of complying with this compliance increases administratively and adds a great deal of complexity to their already heavy workload.
Drawbacks for workers
With some forms of equity compensation, employees might not be able to access their stock options right away because of vesting schedules, employer-imposed use and sale restrictions, or performance-related restrictions. Employees may stay with an unsuitable company until they are fully vested as a result of this circumstance, possibly forgoing greater pay or opportunities at organizations more in line with their needs and lifestyle.
Furthermore, financial gains are not a guarantee for stock owners. Although projections can provide an approximation of prospective earnings, stockholders are susceptible to an erratic market, which can have a substantial impact on the ultimate value derived from equity compensation.
Equity compensation types
Equity compensation is offered in various formats.
Options for stocks
Employees can purchase company stock at a predetermined price by using stock options. Employees are frequently required to hold onto their options until a predetermined period has elapsed before selling or transferring them. Because they may be less motivated to stay with the company if they have instant access to equity, this vested structure deters new hires from purchasing equity shares. However, the employee will ultimately have to purchase them because stock options frequently expire after a specific date.
Limited inventory
All recipients of restricted stock must finish the vesting period; this isn’t always the case with stock options. Restricted stock is typically given to directors and executives as a form of compensation, not to workers. The rights that executives and directors have as stock owners may vary depending on the restricted stock vesting period.
Plans for employee stock purchases
Employee stock purchase plans allow employees to avoid reporting shares they receive after a vesting period on their tax returns. These plans have a special tax benefit because of their structure. As their name implies, you can only make them available to employees; you cannot make them available to shareholders, contractors, consultants, or any other members of the corporate board.
Performance-based shares
This kind of equity compensation is only given to directors and executives who meet predetermined performance standards. Directors and executives are encouraged by this arrangement to concentrate on tasks that boost shareholder value. Shares may still be awarded to individuals who perform exceptionally well, even if the company falls short of these benchmarks. Subcategories within these types offer companies varying degrees of control over the distribution of equity.
Best practices when it comes to paying with equity
Understanding the deal’s structure and the type of equity being offered is essential. An employee may occasionally learn that the company offers options to acquire equity rather than equity itself. Furthermore, there are instances in which the options being provided belong to a different class of equity than the founders.
The employee may be required by the terms of the option plan to exercise their options
within 60 days of quitting the company. Before learning whether the business will succeed and whether the equity will be worth anything, the employee must buy equity.
Any business looking to hire top talent knows that asking an employee to accept a lower salary and offering unfavorable equity terms is not a winning strategy. Here are a few options for fair equity plans:
- By taking on the risk and sparing the employee the expense of exercising the options, the company buys the employee’s options.
- When the options are liquidated, the company repays the employee for the money it loaned them to buy the options.
- To give the employee more time to consider whether their options will increase in value over time, the company has decided to extend the option period from 60 days to 10 years.
In these kinds of talks, an employer might, nevertheless, play hardball and offer prospective employees terms that they don’t like. They ought to assume control of the situation and decide whether to leave or hire an agent or legal counsel to assist in the negotiations. Even though it is simple to believe that stock options will not be significant in the long run, why accept a lower salary in the first place?
In certain situations, a company may even refuse to engage in negotiations. A company’s unwillingness to make concessions may give clues to its workers about how it handles them. It may, at most, indicate a rigid culture. It may, at worst, imply that workers are being taken advantage of. Who would want to work for such a company?
Hiring quality staff is crucial to your business, but it can be challenging to find them. Make sure the person you hire feels good about you and is committed to your mission once you’ve finally found someone with the right skills and a good fit for your culture. You do, however, have options if you make a mistake.
Astute business owners understand that without equitable, transparent, and mutually beneficial employment contracts, it is impossible to find qualified workers. They shouldn’t use complicated contracts and unfair deals to exploit prospective employees.
Prospective employees should speak with an expert if they believe a particular deal is unfair. The specifics of comparable deals should be enquired about. These transactions usually have an easy-to-understand cash component; the equity component is less clear.