We are familiar with big tech giants like Facebook and Google rewarding their employees with stocks. This trend isn’t just a Silicon Valley thing anymore. From Bangalore to Berlin, it is a worldwide phenomenon now. Startups like Flipkart and Urban Company are now rewarding their team with more than just salary – they offer a part of their business. Curious?
So let’s get down to business and understand the whole picture of equity compensation.
The basic concept: Equity compensation meaning
In its simplest form, ‘equity compensation’ is like a ticket to get a slice of the company’s ownership. The reward system goes beyond the usual salary, allowing employees to join the company’s growth journey.
It’s mutually beneficial. On one side, the company can retain top talents and manage costs by not shelling out hefty salaries. On the flip side, employees can enjoy the capital appreciation of their shares.
In essence, equity compensation is like getting a seed. You plant it, nurture it, and then relish the fruits of your effort. It’s a long-term game that intertwines your success with the company’s prosperity.
The bigger picture: Why equity compensation?
Why are companies offering shares instead of cash? The first reason is that many startups don’t have immediate cash flow to pay competitive salaries, but they have a bright future full of potential. They’re giving you a slice of that potential by offering you shares.
By giving out shares instead of cash, they can hold onto their money for other essential things, like buying new equipment or investing in research and development.
There’s also motivation. When you own a part of the company, your success is linked to the company’s success. It means you’re motivated to do your best to make the company successful.
Types of equity compensation
Equity compensation cannot be applied to everyone in the same way. It is tailored according to the company’s needs and the circumstances. Some firms use it as a cherry on top of their employee benefits, while others use it as the main dessert, especially those startups who are tight on cash.
According to a Morgan Stanley report, over a third of private firms now offer their employees equity compensation. So let’s dive in and explore the different equity and competency-based compensation types currently making waves in the corporate world.
Businesses offer stock options, meaning you can purchase limited company shares at a set price called strike or exercise price. It remains fixed, even if the company’s share price rises sky-high on the stock market.
But you must work for the company for a specific period, known as the vesting period before these stock options become yours to sell or transfer.
For example, take the case of Zomato. They granted employee stock option plans of 2.52 crore shares to selected employees with a face value of Rs.1.
Stock options are of 2 types, one is Incentive Stock Options (ISOs), and the other is Non-Qualified Options (NSOs).
NSOs are a type of stock option that you don’t need to declare when you receive or use them. But it incurs more tax on sale.
ISOs come with tax benefits. However, ISOs are only for employees. If you’re not an employee, like a consultant or a non-employee director, you can’t receive ISOs.
Restricted stock units
So what are RSUs? Think of them as promises from your company to give you shares later. They’re called ‘restricted’ because there are certain conditions to meet before you can get your hands on them.
Instead of buying shares as you would with stock options, with RSUs, your company gives you the shares (or sometimes the cash equivalent) once you’ve hit certain goals. These could be either remaining employed for a certain period of time or meeting particular performance goals.
For example, take the IT giant Infosys. On March 31, 2023, Infosys granted RSUs to its employees. These RSUs were granted to Key Management personnel (KMPs), Senior Management, and other eligible employees, totalling around 7 lakh units.
It also mentions four years of vesting period with equal vesting. It means that the employees will gain ownership of 25% of their allotted RSUs each year over the course of four years.
Also, in Infosys, if an employee who has been granted RSUs resigns or is terminated before the RSUs have vested. It will automatically be terminated if the vesting criteria have not been met.
When you get RSUs, there’s no immediate tax, but once they vest, you pay income tax on the value. If you sell them in less than 2 years, then you have to pay tax according to the tax slab. If you sell after two years, they’re taxed as long-term capital gains with an indexation facility.
In a nutshell, RSUs are like a ‘thank you’ from your company that could turn into a profitable surprise down the line.
When talking about equity in compensation management, here’s another star performer- Performance Shares.
Employees earn performance shares by hitting specific targets set by the company. The targets can be anything from improving the company’s earnings per share, boosting return on equity, or perhaps outperforming a business index.
And remember, these targets aren’t achieved overnight, it usually takes years. So, performance shares are a way to reward long-term, sustained effort.
In the previous example from Infosys, alongside RSU, Performance Stock Units (PSU) were also granted. Here it is a three-year equal vesting period, provided only on achieving performance targets as given in their 2019 plan.
Employee Stock Purchase Plan
Employee Stock Purchase Plan, or ESPP, is a part of equity compensation, meaning it’s one way a company rewards its employees. But it works differently than other forms of payment. With ESPP, an employee can purchase shares at a discounted price compared to the general public.
Each month, a certain amount of your salary is automatically deducted to purchase your company’s stocks at a discounted price.
Of course, there is a cap on how much you can contribute, and you’ll be taxed when you buy and sell the shares.
ESPPs can be an attractive addition to a company’s equity compensation accounting, especially for publicly listed companies that aim to share their success with employees.
Equity compensation: Not always a bed of roses
The concept of equity compensation may seem appealing, but there are certain drawbacks to it.
- It’s Complex: There are different types, like RSUs and PSUs, each with its own rules. Mistakes can lead to significant tax bills or missed chances.
- The waiting game: You can’t always access your equity right away. Vesting periods, often lasting a year or more, mean you must wait to claim your shares.
- Taxes: The tax situation can be tricky. Depending on the type of equity, you might face unexpected tax bills.
- Risky Business: If most of your wealth is tied to your company’s stock, it’s a gamble. If the company struggles, your financial health could too.
Also Read: Understanding the P/E ratio
Equity compensation, meaning offering shares of the company as part of a pay package, can be an attractive prospect. This approach can allow businesses to save cash while also allowing employees to purchase shares at a reduced price.
However, the value of these shares can fluctuate due to market volatility, so there’s risk involved. It’s not as straightforward as a regular salary.
Thus, when considering an offer with equity, it’s wise to seek a balance. Pairing up both cash and equity in your compensation can give you a safety net. Always aim for well-rounded deals.