Businesses of virtually any size can choose from among several types of equity compensation to empower employees to earn company ownership stakes (i.e. equity) instead of — or in addition to — employee salary. Broadly speaking, that’s how employee equity compensation works: employees receive all or part of their compensation in the form of company stock.
The equity compensation you choose to offer can have the literal effect of making employees more invested in the success of the company. That investment has the potential to drive employee loyalty and performance, along with other important benefits equity compensation plans can provide.
But there are several different types of equity compensation plans. Each has specific characteristics that impact whether it might be the right fit for your business and your employees. In this article, we’ll take a look at some of the more commonly used equity compensation types and their differences.
Why Companies Choose to Offer Equity Compensation
There are plenty of reasons to consider adding equity compensation to your business’s overall strategy to fairly and equitably compensate employees. Equity compensation plans can:
- Help align employee objectives with company objectives by more directly tying compensation to profitability (and, therefore, share price)
- Reduce the cash requirements needed to meet payroll expenses (a common strategy among startups with less available cash)
- Motivate individual employee performance (specifically using equity-based performance plans)
- Offer an attractive added benefit to hire and retain employees
Of course, equity compensation options can have their own disadvantages, too:
- Some founders/owners don’t like the idea of “giving up ownership” of their company
- Risk-averse employees may not find equity compensation attractive
- Privately owned companies call for professional valuation to assess share values for IRS purposes
- Rules and regulations around nondiscrimination requirements and taxation can add significant complexity to the compensation process
Types of Equity Compensation
Nonqualified stock options (NSOs) are fairly common, often granted not only to payroll employees, but also to contractors, directors, consultants, advisors, or other service providers. An NSO offers recipients the choice to purchase company stock at a discounted strike price. Employees can profit if the stock price rises and they sell. NSOs are taxed as income* when exercised (i.e. when shares are purchased) on the difference between the exercise price and fair market value.
Incentive stock options (ISOs) are similar to NSOs, but they’re not taxed until the employee (or optionee) sells or otherwise disposes of their shares.* ISOs can only go to employees, and their preferential tax treatment comes with some complex rules around grant date, exercise, holding period, etc.
When an employee holds the stock and sells later, they are taxed at capital gains rates.*
Restricted Stock Units (RSUs)
An RSU is not a share. Rather, it’s a commitment to deliver a share to an employee in the future, after all vesting requirements have been met. So employees don’t have full ownership of the shares right away. They may have to meet service requirements or achieve specific key performance indicators (KPIs) to become fully vested. But when they do achieve full ownership, they get the full dividend and voting rights that come with the shares. RSUs are taxed as ordinary compensation when they vest, and as capital gains when sold.
Phantom Stock and Stock Appreciation Rights (SARs)
Neither of these compensation types refer to actual stock share ownership. Rather, these are ways to tie payments to employees (or others) to the value of company stock.
A SAR is a contract that allows the recipient (employee or contractor) to receive the increase in value of a specified number of shares over a specified period. Phantom stock is similar, but often offered to senior staff, and often with a long delay between the award and the financial payout (subject to contract agreement). As units of phantom stock become vested, their value is counted as wages subject to income tax.*
Employee Stock Purchase Plans (ESPP)
ESPPs can be either qualified or non-qualified. Qualified ESPPs are subject to IRC Section 423 — but they’re not ERISA-regulated qualified retirement plans. So employees don’t necessarily have to wait for retirement to receive proceeds from the sale of shares purchased through an ESPP. That said, rules for qualified ESPPs are quite specific.
Non-qualified ESPPs aren’t subject to the same restrictions and nondiscrimination rules; neither do they qualify for favorable tax treatment. More companies tend to use qualified ESPPs than non-qualified.
Both types of ESPPs typically offer purchase periods during which employees elect to have funds taken out of their paychecks to purchase company shares on purchase dates within the offering period either at a discount or with a lookback provision to get a lower purchase price.
READ MORE: Equity Ownership or Profit Sharing? Who, When & Why to Offer It?
What About Employee Stock Ownership Plans (ESOPs)?
An ESOP is an equity-based, tax-deferred employee compensation plan that is a qualified retirement plan, subject to ERISA. Unlike stock options and stock purchase plans—but similar to RSUs—in an ESOP, the company provides employees with the benefit of ownership interest in the business over time.
Unlike RSUs, employee-owners in an ESOP are beneficial owners — because the ESOP trustee is the legal owner of the shares. Employees receive the equivalent of the value of their allocated shares as a retirement distribution, subject to vesting requirements, when they leave the company or retire.
But an ESOP is more than a qualified retirement plan. It also offers a uniquely flexible exit strategy for owners of privately held companies who want to diversify their wealth or access liquidity without having to leave their company behind as they might in a merger, acquisition, or other third-party sale. In fact, many selling business owners stay on as leadership employees and become employee-owners over time.
Understand how an ESOP works as a qualified retirement plan to recruit and retain quality employees — and its unique benefits to selling shareholders, companies, and the communities where they do business. Just click below for the video.
*Refers to U.S. federal income tax.