Companies need to hire the best talent possible to ensure continued success. Of course, one of the most effective ways to attract and retain employees is to offer an attractive compensation package. But for new businesses or startups, cash is in low supply, so equity compensation can help entice valuable employees without stretching the budget.
When done right, equity compensation functions as a win-win for both you and your employees. 53% of millennials report that equity is the main reason they chose their current employer. For your organization, it is an effective way to attract top talent without affecting cash flow.
In this article, we will discuss equity compensation, why it matters, and how to offer it to your team.
What Is Equity Compensation?
Equity compensation involves providing partial ownership in your company as payment for the employee's work contributions. Equity-based compensation grants stock options or other legally enforceable financial instruments to align employee and company interests.
Providing an equity compensation plan can promote team longevity and reduce turnover, two factors that are crucial to building the value of your company. Getting paid in equity is a sign of pride for employees, as they feel as if they are truly a part of the company.
With this model, team members tend to be more committed and will work harder and longer. As a result, the customer experience improves along with your company's revenues.
Which Companies Offer Equity Compensation?
C-corporations are more likely to offer equity than a small LLC corp. The startup ecosystem is typically dominated by C-corp companies that function as early-stage businesses.
Since most C-corporations desire rapid business and revenue expansion, they often search for external investments such as venture capital to boost growth. Startup investors want to see a positive return on their money, so high-growth startups experience increased pressure to bring highly qualified leaders on board.
Startup equity compensation is one approach that C-corporations use to ensure that company leaders stay around for at least a few years. Any executive who receives equity has an incentive to commit to the company for longer, while the company reduces expenses by not paying an immediate full-time salary.
LLCs, unlike C-corps, tend to advance at a slower pace. Organic growth takes place over a longer time period without as much need for venture capital, so startup equity compensation is not always a feasible strategy for LLCs.
Why is Equity Compensation Important?
Offering an equity compensation plan is beneficial to you and your company for several key reasons:
- Conserve your cash: Early-stage startups typically find it challenging to achieve healthy cash flow. Challenges with cash flow can extend beyond the first few years, making equity-based compensation an attractive option. Startup equity compensation can limit expensive salaries that might threaten to destabilize your finances.
- Attract top talent: Finding top talent is a never-ending priority for startups. However, unlike established Fortune 500 companies, startups don't have the deep reserves to provide lucrative corporate salaries. To remain competitive in the acquisition and retention of premier talent, startups leverage equity compensation.
- Minimize employee turnover: Startup equity compensation is designed to improve employee longevity. Equity compensation virtually always includes vesting periods that tie employee equity to a set of restrictions. Employees must reach time and performance milestones to gain ownership of their shares.
- Enhanced involvement: Since startups have fewer employees than their behemoth competitors, these new companies must ensure early employee involvement. The base team may be a fraction of the size of its nearest competitor, so loyalty and work ethic are fuel for a startup's growth. Employees are better motivated knowing their input will directly grow the value of their shares.
Main Types of Equity Compensation
An equity compensation plan almost always comes with conditions. It is rare for a company to grant equity outright due to unpredictable employee actions that could severely damage the company's finances.
Startups typically issue equity in one of three ways: stock options, restricted stock awards, or restricted stock units. Let's explore each one in detail:
A stock option is a shareholder’s right to purchase a specific number of company shares at a pre-set price. Stock options are the more common way that early-stage startups grant equity to employees. The stock option holder is not a shareholder until they officially exercise their option.
However, stock options are a right, not an obligation. The employee can choose not to purchase their stock, but they will lose their right to purchase after an agreed-upon timeframe.
The shareholder does not have voting rights either until agreeing to purchase their stock options. The price of the stock that the employee must pay (also called the strike price) depends on the stock option agreement.
Restricted stock awards
Restricted stock is a share of a company that shareholders can not transfer until certain conditions have been met. It is possible to issue company stock in exchange for an employee's work. However, directly issuing stock is not common. If restricted stock awards are the chosen compensation method, a startup often elects to place restrictions on the awarded stocks.
Common restrictions for stock awards include:
- Vesting: The employee must remain with the company for a certain period of time before owning their stock award.
- Transfers: To change the nature of their stock, the employee must request permission to transfer it.
Companies typically limit restricted stock awards to early hires or top executives due to the expensive tax implications of this type of equity.
Restricted stock units
A restricted stock unit is an agreement between the company and employee to issue stock shares at a specific future date. RSUs are not the same as restricted stock awards. Each unit is equivalent to one share of stock or that stock's cash value.
The "unit" of an RSU refers to the contractual number linked to the future stock's value, not to an options contract or a direct stock award.
To receive the share or cash for their RSU, the employee must vest. The date at which they receive their compensation is known as the settlement date. The settlement date can be predetermined or tied to an event, such as the startup's Initial Public Offering (IPO).
Small private companies commonly issue RSUs in favor of other equity instruments to avoid registering as a public company (Facebook was one of the early pioneers of this RSU strategy).
How is Equity Compensation Calculated?
It can be a challenge to calculate the proper value of an equity compensation package. Various reasons affect the potential ownership percentage, such as the employee's role (C-suite would earn more than low-level management).
For example, a typical early-stage startup may issue equity as follows:
- Senior Engineer: 1%
- Senior Business Development Employee: .35%
- Mid-Level Engineer: .45%
- Junior Engineer: .15%
- Junior Business Development Employee: .05%
When Can Startups Offer Equity Compensation?
There are legal restrictions to follow before you can issue stock and other forms of startup equity compensation. Startups typically need to wait until they undergo a 409a valuation.
A 409a valuation is a process that determines the fair market value of your company's common stock. The market value you receive can change from the valuation that investors applied to your company during fundraising.
Therefore, you will need a new official valuation after raising funds, and that amount will determine at what price you can issue equity for advisors, employees, and anyone else.
If you fail to issue stock in line with a 409a valuation, you could face legal and tax trouble with the IRS.
Should You Accept Equity As Compensation?
You should always discuss personal financial decisions with a financial advisor, attorney, or CPA. Equity compensation carries different tax implications and timelines that are difficult to navigate if you are not a financial professional.
If you neglect to seek advice for your equity compensation plan, you could experience serious issues such as higher tax bills or missed opportunities to exercise your shares.
In addition to consulting a professional advisor, you should personally read your compensation agreement, paying attention to conditions such as:
- The vesting date
- The exercise date
- The strike price
- Potential blackout periods
- Any additional restrictions
A Zero-Equity Solution
Equity-based compensation can be the right choice in certain situations. It enables companies to stabilize cash flow while enhancing employee loyalty and motivation. However, if your startup does not want to issue equity to retain top talent, there are other options.
MassChallenge assists startups with growth, connection to resources, and access to industry-leading mentors—but does not take equity. By keeping more equity, your founders can enjoy a more lucrative IPO or other beneficial exit strategies in the future.