Should You Offer Equity as Compensation?

What is equity compensation?

Equity compensation is a noncash form of compensation through which employees receive a partial stake in the company that employs them in lieu of (or in addition to) a salary. The arrangement is often used to improve a business’s cash flow, since they don’t have to spend as much on payroll.

This type of pay structure is becoming increasingly popular in full-time employment contracts for startup businesses that are short on cash but have high potential for future growth and profits. A study by Morgan Stanley at Work found that 76 percent of HR leaders surveyed said their company offers some form of equity compensation benefit, up from 65 percent in 2021.

Equity compensation and good compensation management come with certain terms, and the employee may not earn a return at first. Let’s say you hire a chief technology officer at a salary that is 35 percent below market rate. To offset that, you provide them with a stake in the company. In a few years, the company may triple its revenue and pay significant dividends to its employee shareholders.

According to Tamanna Ramesh, founder of Spark Careers and director of global innovation programs at a Fortune 100 company, equity compensation plans can be a powerful draw for employees, especially when they align with the company’s mission and growth potential. “The biggest benefit is the opportunity for wealth creation if the company performs well, fostering a sense of ownership and engagement,” Ramesh said.

The Morgan Stanley study reflects that sentiment: 95 percent of survey respondents agreed that equity compensation is “the most effective way to keep employees motivated and engaged.” Ramesh cautioned, however, that companies offering it must first assess their financial health. “If the value declines, equity can quickly become worthless,” she said.

 [Read more about which employee benefits packages you should offer.]

How is equity paid out?

Equity may be structured differently from company to company, and how it’s paid out depends on the type of equity offered. There are two main types of equity.

• Vested equity: In this type of equity, shares are earned over time through a vesting schedule. That means employees must stay with the company for a certain period of time before gaining full ownership of their shares.
• Granted stock: This type of stock is provided upfront with full immediate ownership, but it may come with restrictions on selling or transferring shares right away. 

Equity offers the potential for significant financial upside, but employees who accept equity compensation assume the risk that their shares may not ultimately be worth what they anticipate and that payout is not guaranteed if the company doesn’t perform as well as expected. They also agree that they are accepting equity in place of a salary or as a supplement to a lower-than-market-rate salary.

Types of equity compensation

There are several types of equity compensation you can offer your employees. Below are some of the most common.

Stock options

Stock options allow employees to buy shares of the company stock at a preset price. In many stock purchase agreements, employees must wait to sell or transfer their options until after a certain amount of time has passed. This vested structure encourages employees to stick with the company long enough to see their options become valuable. Since the stock options typically come with an expiration date, however, employees must act before losing the opportunity to buy in and gain ownership of the shares they’re offered.

There are two primary types of stock options, and each has different tax implications:

• NSOs (nonqualified stock options) are available to employees, consultants and board members, and are taxed as ordinary income when exercised.
• ISOs (incentive stock options) are available only to employees of a company and offer special tax advantages. Capital gains can be taxed at lower rates if certain conditions are met.

>> Free Tool: Stock Option Calculator

Restricted stock

Unlike stock options, restricted stock represents an actual share of company ownership and comes with rights, such as voting and dividends. For that reason, restricted stock is typically offered as compensation only to executives and directors rather than lower-level and midlevel employees.

Restricted stock may be offered with full rights and ownership upfront (restricted stock awards or RSAs) or with a vesting schedule (restricted stock units or RSUs). With RSAs, employees may have to give back shares if they leave the company before a certain period of time. With RSUs, employees must complete a vesting period before they gain full shareholder rights and ownership of their shares. In either case, this equity structure encourages employees to stay with the company.

Employee stock purchase plans

Employee stock purchase plans allow employees to buy shares of a company — often at a discount — through payroll deductions. The plans typically have a vesting period, but they also come with a tax advantage: Employees don’t have to report shares as taxable income until they sell them.

Since the plans are available only to employees (not contractors, consultants or board members), they can be a great way for companies to build a culture of ownership while giving employees a financial stake in the company’s future.

Performance shares

Performance shares are granted only if specific company metrics — such as earnings per share (EPS), return on equity (ROE) or stock price growth — are met over a multiyear period. Even if the company as a whole falls short of performance goals, individuals with outstanding performance may still be given the shares. This arrangement incentivizes executives and directors to focus on work that increases shareholder value while rewarding high performers.

Benefits of equity compensation

Both employers and employees can reap the benefits of equity compensation. The arrangement provides a financially flexible alternative for businesses — particularly those with limited cash reserves for salaries — and serves as an attractive business prospect for employees.

Pros for employers

• Better cash flow. Equity compensation allows companies to increase cash flow by reducing their payroll expenses.
• Possible tax advantages. Depending on how equity is structured, companies may benefit from tax-saving opportunities that improve their financial health.
• A more motivated and loyal workforce. Employers will likely find that those who accept equity compensation work harder, motivated by the understanding that their earnings are linked to the company’s performance. If there is a vesting schedule tied to the equity, employees will also be more encouraged to stay with the company through that period.

Pros for employees

• Potential for higher long-term earnings. If the company performs well, equity can be worth significantly more than a traditional salary or monetary bonuses in the long run.
• Diversified investment portfolio. Company stock is an additional investment asset alongside traditional income streams.
• Deeper sense of ownership and commitment. When their financial compensation is tied to company performance, employees often feel a deeper sense of commitment to the company and have extra incentive to work hard.

Disadvantages of equity compensation

Although equity compensation can provide great benefits to employees and employers, employers should be aware of its complexities, which can be a notable downside.

Cons for employers

• Administrative and compliance burdens. In addition to managing an equity compensation program, companies must also adhere to complex tax laws, reporting obligations and jurisdictional regulations, which can increase administrative workload.
• Potential equity dilution. As new funding rounds occur or new employees join the company, the existing equity may become diluted and decrease the ownership percentage of existing shareholders.
• Potential employee dissatisfaction. If a company’s stock underperforms or lacks liquidity, employees may feel undervalued and seek other opportunities.

Cons for employees 

• Delayed access to equity earnings. Vesting schedules, ownership structures and performance-based restrictions may prevent employees from selling or accessing their equity right away. Employees may feel pressured to stay with a company that doesn’t suit them until they are fully vested, potentially foregoing higher salaries or opportunities at companies better aligned with their needs and lifestyles.
• Unexpected tax consequences. Certain forms of equity, such as RSUs in private companies, can result in tax liabilities even if employees can’t sell their stock immediately.
• Financial uncertainty. Owning company stock doesn’t guarantee financial returns. Projections can offer an estimate of potential earnings, but stockholders are not immune to an unpredictable market, which can significantly affect the final value received from the equity compensation.

Best practices for using equity as compensation

Equity compensation can be a powerful advantage for both businesses and employees — when structured correctly. Here’s what employers should know about designing a successful equity compensation plan.

Consider your growth stage

Makadia advises startups to structure their equity compensation based on their stage of development so they can ensure it’s most tax favorable to the employee. “Generally, stock grants are best at the very early stage,” Makadia said. “Once the startup has raised investor funds, the employer should likely switch to options. And once the employer gets closer to IPO [initial public offering], RSUs make the most sense. These are all designed to ensure maximum tax efficiency.”

Balance short-term and long-term incentives

Ramesh encouraged companies to strike a balance between short-term compensation needs and long-term incentives when designing equity packages. “A well-structured equity package should include a clear vesting schedule — typically three to four years — to drive retention and reward performance,” she said.

Be transparent about valuation and liquidity

Transparency is key to making equity compensation attractive and sustainable. According to Ramesh, companies should make sure employees understand how their equity is valued, the potential impact of future funding rounds, and the likelihood of liquidity events. “I’ve found that the most successful programs align employee performance with company growth, [which creates] a sense of shared purpose and ownership while ensuring long-term sustainability for the business,” she said.

Accepting equity as compensation: what employees should consider

Before accepting equity as a form of compensation at a new job, here are a few important considerations and negotiation tips. 

Understand the risks and potential rewards

Equity compensation can lead to significant wealth creation, but it’s not a guaranteed payday. Ramesh recommended carefully evaluating a company’s financial health before accepting equity. “Get clarity on the valuation of the equity and understand the company’s stage — whether it’s a startup, scale-up or established business,” she said. “If the company’s potential seems uncertain or if the risk feels too high, I advise negotiating for a higher base salary or a more favorable equity stake.”

Negotiate for favorable terms

Employees should negotiate beyond just the number of shares offered. Makadia recommends asking for acceleration clauses upon a change of control, which means you won’t lose out on unvested shares if the company is acquired.

Consider the risk of dilution

Equity offers can lose value over time if a company issues more shares during future funding rounds. “Dilution is hard to control … and it’s very rare for employees to be granted antidilution protection,” Makadia said.

Employees should ask about the company’s fundraising plans and how additional stock issuances may affect their ownership percentage.

Plan for tax implications

Equity compensation comes with tax considerations that employees must understand upfront. RSUs in a private company, for example, may create a tax burden even if the stock isn’t liquid. “Make sure there is a public market so you can sell the stock and cover your tax burden once the RSU vests,” Makadia said. “If the RSU grant is in a private company, usually the grant won’t be fully vested unless there is a triggering event like a sale or an IPO.”

It is always a good idea to consult a tax professional before signing an equity agreement to prevent unexpected liabilities down the road.

With a well-designed equity compensation plan, employers can attract and retain top talent, align incentives, and preserve cash flow, while employees get the opportunity to own a stake in a company’s future and potentially build long-term wealth. Understanding the terms, risks and long-term implications of an equity compensation plan is key to making the most of this opportunity. 

Sean Peek ​​and Max Freedman contributed to the reporting and writing in this article.