Creating a Plan for Equity-Based Compensation
Whether you just founded your business, or you’re a growth-stage startup, chances are you’ve considered offering equity as a form of compensation to your team. But do you know when, why, or even how to offer equity compensation to your people? Let’s dig in to find out.
Ultimately, if you’re thinking about creating an equity-based compensation plan to motivate your employees and grow your company’s worth, it’s important to understand your how and why.
What is Equity-Based Compensation?
By definition, “equity-based compensation” includes any compensation paid to an employee, director, or independent contractor that is based on the value of specified stock (generally, the stock of the employer, which may be a corporation or a partnership).
Examples of equity-based compensation include:
- Stock options
- Restricted stock
- Restricted stock units
- Phantom stock plans
- Stock appreciation rights
- Other awards whose value is based on the value of specified stock
Equity-based compensation is an important and valuable part of a total compensation package. Yet, few employees fully understand what they’re getting, why it’s valuable, or what to do with it. Companies, on the other hand, want to offer it to entice or retain talent, but rarely understand the full implications and complexities of offering this type of compensation.
You might commonly know them as “stock options,” but equity-based compensation is an investment opportunity that gives the holder the ability to buy a certain amount of shares of company stock at a locked-in price. When they exercise stock options, they buy shares of stock at the locked-in price.
Most Common Types of Equity-Based Compensation
Although there are many types of equity-based compensation, the two most common types are
- Stock options – the right to buy common stock
- Restricted stock – a direct award of stock
Although both have value to the recipient, they are very different — especially when it comes to how they’re taxed (i.e., at award or once vested). It can get complicated quite quickly.
Why offer Equity-Based Compensation?
Early on, many companies build equity-based compensation plans in order to offset the cost of compensating employees with cash. They want to entice and retain good employees who will grow the value of the company over time. Building equity compensation into overall compensation packages gives your employees a vested interest in creating success for the company and often encourages them to stay throughout the period their stock options vest. Typically, they’ll need to stay with the company for a period of time (often four years) before they earn the right to buy their shares. Because employees receive the right to purchase more stock for every month or year they’re at the company, they’re inherently motivated to stay longer than they might have if they didn’t stand to receive stock options.
The key is designing the plan before you pull the trigger on issuing any awards.
When Is the Right Time to Offer Equity-Based Compensation?
Although there is no right or wrong time to consider implementing an equity-based compensation plan, we see it most commonly in the early stages of startups because it’s a good way to augment cash compensation. Beyond founders’ stock, which is typically issued to the original founders of the company, we see three common cases for equity-based compensation.
- When making the first hire after initial founders
- When making technical hires
- When bringing on key strategic advisors and industry board members
These are all good times to offer equity-based compensation because they’re not only valuable to employees and key stakeholders, but they serve as great motivators to encourage them to work hard and build the company’s value. They can reap the reward of growth in the share price along with the founders and investors.
The key is designing the plan before you pull the trigger on issuing any awards. You’ll need a plan before making promises. At the very least, the document should include a strategy for who will receive awards, when the awards will be given, and how much each participant will receive.
Ultimately, if you’re thinking about creating an equity-based compensation plan to motivate your employees and grow your company’s worth, it’s important to understand your how and why. Setting up your plan correctly from the beginning will save you time, money, and headaches along the way.
We could talk about this all day, so let’s say we’ll share more down the line, shall we? In the meantime, if you have questions, reach out to us. We specialize in early-stage startups and can help you design a stock options plan that works for you and your business.
Book+Street provides strategic financial and tactical finance and accounting services to enhance your current team and support strategic initiatives.