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Equity Based Compensation: Comprehensive Guide

  • Written Written by Sanya Gupta 07 June 2023 | 4 min read
  • Editor's Note :

    Equity-based Compensation has become a potent tool for luring and keeping talent. This blog examines its advantages, benefits & implementation tactics. To empower your workers & promote long-term success, explore the stock options, restricted stock units, & employee stock purchase plans.

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Bootstrapped or cash-burning startups frequently seek methods to reduce their expenses. During the initial stages of development, saving even a small amount of money means having additional resources to reinvest in the startup, enabling faster growth. However, what does it mean to compensate with equity, and why do numerous firms consider it a viable choice?

Especially in startups where traditional salary packages may not always be enough to entice and retain top talent, businesses across various industries are increasingly exploring alternative compensation models.

Imagine a scenario where your employees have the option to receive not only a component of compensation but also a share in the company's ownership. This is the power of equity-based compensation, where employees can choose to accept a reduced salary in exchange for the opportunity to grow with the company.

Sounds confusing, right? Let's unravel this concept for better clarity.

Beyond Salary: What is Equity Compensation?

Although monetary incentives have traditionally served as the standard approach for rewarding employees, this ultimately falls short in terms of effectively retaining them over time. Equity-based compensation, often associated with startups, has transcended its niche, and is gaining popularity among businesses of all types. How can this approach revolutionize the employee experience and drive organizational growth?

Equity-based compensation creates a contract between a company and its employees, helping them to get company shares at a fixed price upon meeting specific conditions. It is a form of non-cash compensation that give employees the potential for financial gains and a stronger sense of ownership in the business. It also aids in retaining employees and accelerating business growth for startups.

In 2022, employees of startups reaped significant rewards from equity-based compensation included in their remuneration packages. A recent report by Inc42 revealed that employees collectively gained $196 million through ESOP (Employee Stock Option Plan) buyback programs implemented by their respective companies. These programs allowed employees to sell their vested shares and realize financial benefits. Alternatively, employees had the option to retain their equity and potentially profit from its future sale.

Salary + Equity: Combining for Comprehensive Compensation

Esop compensation

It's important to note that equity compensation and traditional salary systems are not mutually exclusive and should be used in combination to create comprehensive compensation that suits the needs of both the company and its employees.

Cracking the Code: 7 Must-Know Terms in Equity-Based Compensation

equity Based compensation

Familiarize yourself with these essential keywords before you delve into equity-based compensation:

Employee Stock Option Plan (ESOP) – This plan allows employees to acquire company stock and become shareholders.

Vesting – The process through which an employee earns the right to purchase the stock.

Vesting Period – The designated timeframe within which an employee must fulfill specific requirements to qualify for the benefits of their equity-based compensation plan.

Exercise – The act of buying shares once they have vested.

Exercise Period – The timeframe within which an employee must exercise their stock options after the vesting period concludes.

Exercise Price – The price at which an employee purchases each share.

Grant/Strike Price – The pre-established price at which employees can buy company shares when they exercise their stock options.

4 Types of Equity Compensation

types of equity compensation

Equity compensation comes in various forms, offering distinct advantages tailored to each unique business scenario. There exist five types of equity compensation, each presenting its own set of benefits aligned with the specific needs and goals of the company.

Employee Stock Options Plan (ESOPs) - ESOPs grant employees the right to purchase company stock at a predetermined price, known as the exercise price or strike price. For example, Company X offers its employees stock options that allow them to buy company shares at $10 per share within a specified period.

There are 2 types of Stock options: -

Restricted Stocks: - RSUs are awards of company stock that vest over time or upon achieving specific performance goals. For instance, Company Y grants its employees RSUs worth 100 shares that will vest over a four-year period, with 25% vesting annually.

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Performance Shares: - are a type of equity compensation that link the value of shares granted to an employee with specific performance goals or targets. The number of shares awarded depends on the achievement of predetermined performance metrics.

For example, Company X grants performance shares to its executives based on the company's revenue growth. If the company achieves a 20% increase in revenue over a specified period, executives may receive a certain number of shares as a reward. If the target is not met, the number of shares awarded may be reduced or eliminated.

Employee Stock Purchase Plan (ESPP): - This type of stock provides employees with the opportunity to acquire company stock at more affordable prices compared to the regular market rates. The company extends a discount ranging from 5% to 15% below the fair market value (FMV) of the stock, and the cost is deducted incrementally from the employee's paycheck.

Upon completion of the payment for the stock shares at the discounted price, employees gain full ownership and control of the shares on the designated purchase date.

For more such information on types of Equity Compensation, you can read up on Employee Stock Options for Employee Compensation

From Employers to Employees: What are the benefits of Equity Compensation?

benefits of Equity Compensation

Benefits for Employers

Attracting & Retaining Talent – Equity-based compensation helps organizations with attracting highly skilled and motivated employees who stay committed to long-term success.

Motivating & Aligning Interests - When employees have a stake in the company's performance and success, they are more likely to be motivated, take ownership of their work, and strive for excellence.

Cost Management – It helps in conserving cash flow for the company, especially during early stages or periods of financial constraints. By granting equity instead of cash-based incentives, businesses can allocate resources strategically and minimize immediate financial burdens.

Increasing productivity by building a team – Employees with equity compensation will likely do far more than the bare minimum and gets a sense of ownership as they now have a voice through shareholder voting.

Benefits for Employees

Long-Term investment with great ROI - Equity compensation provides employees with the opportunity to benefit financially if the company's stock value increases over time. As shareholders, employees can profit from the growth and success of the organization, potentially generating significant wealth.

Ownership and Job Satisfaction – Employees now have a voice in the company’s decisions and direction. By holding shares, they gain a sense of ownership and the ability to participate in voting rights and company governance, influencing strategic decisions.

Recognition and Appreciation - Being granted equity compensation can be a form of recognition and appreciation for an employee's contributions to the company. It demonstrates that the company values its efforts and sees them as integral to its long-term success.

Equity Compensation Made Easy: Vega Equity

Choosing the right equity compensation tool is crucial for accurate administration, compliance with legal requirements, transparent communication, scalability, data security, and seamless integration. It empowers companies to effectively manage equity compensation programs, enhance employee engagement, and support their growth objectives.

With Vega Equity, employers can grant ESOPs to all the deserving employees within a few clicks and manage the end-to-end allotment with ESOP Pool creation, grants, vesting management, and more. It also offers real-time updates and visibility, a paperless management system, and intuitive dashboards for all stakeholders involved.

For more such information, you can talk to our Vega Equity experts

Wrapping Up

In conclusion, equity-based compensation offers a powerful incentive structure that aligns the interests of employees with the long-term success of the company. By granting employees ownership in the form of different types of stocks, companies can motivate and retain talented individuals while fostering a sense of ownership and potential financial gain. This compensation approach can drive employee loyalty, promote a culture of integrity, and provide significant financial rewards.

However, it is crucial for companies to carefully design and communicate their equity-based compensation plans and decide on the appropriate compensation tool to ensure fairness, transparency, and proper risk management. Overall, when implemented effectively, equity-based compensation can be a valuable tool for attracting, motivating, and rewarding employees in a dynamic and competitive business environment.

About Vega Equity

Vega Equity offers companies an effective, intuitive, and paperless platform for managing equity. It provides accurate cap table management, customized user experiences, and precise information. Additionally, it assists in measuring KPIs, analyzing data, and tracking performance towards goals.

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