For startups, equity rewards are the most practical and trending form of remuneration. Granting equity in exchange for services to the company appears to be a mutually beneficial arrangement for both the recipient and the business.
Before deciding on an equity plan, it is important to consider the legal, tax, and accounting aspects. An in-depth look at all the options available to a company is provided in this article.
Equity Award Schedule
The vesting schedule of equity awards should be taken into consideration. Lack of vesting schedules increases the risk of distributing stock without evaluating the employee’s performance and dedication to the company. Read further to have a better understanding.
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What is an Equity Award?
An equity award is a form of non-cash remuneration that is paid in the form of business stock. In most cases, this is given in addition to a lower-than-market income. It’s a wonderful recruiting and retention technique for early-stage firms that need the best people but don’t have the funds to pay for them.
In order to compete with giant corporations’ high-end remuneration, these companies must give employees equity share in the firm instead of just cash compensation.
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How do Equity Awards Help Grow a Company?
Companies can save money on salaries by providing equity compensation to employees. When a new company relies on seed investment and does not have a substantial cash flow, equity awards can help a company grow quickly as the money can then be used for operations, new projects, and investments.
Types of Equity Awards
All forms of equity rewards provide employees with the choice to purchase stock. A few schemes grant shares directly, but all have vesting schedules. There is a wide range of tax consequences associated with all equity schemes. Here are a few of the most popular equity grants:
Stock Options
As the name implies, beneficiaries of this sort of equity award have the opportunity to purchase firm stock at a later date at a predetermined price. The fair market value of the shares can only be determined by a professional valuation, which is why 409a valuations are required before these options can be granted. Employees receive the ‘option’ to purchase a specified number of shares at the award date after the vesting period has ended.
It’s up to the employee to decide whether or not to exercise their options after they’ve vested. Share prices are expected to have risen by that time, allowing employees to benefit from the difference between grant date fair market value and exercise date actual market price. There are two kinds of stock options:
Incentives for Stock Options
To be given to staff only. Taxed at the capital gains rate rather than the standard high-income tax rate.
Non-qualified Stock Options (NSO)
It’s open to everyone who wants it. Ordinary income tax rates apply, although ISO-specific rules do not. NSOs allow for more adaptability.
Stock Appreciation Rights (SARS)
SARS is a program in which employees of a firm are eligible to receive cash due to an increase in the company’s stock price, subject to specific vesting conditions. Cash is the medium of payment for this sort of equity compensation. The beneficiary does not receive actual stock or the right to purchase stock. In place of shares, SARs provide a cash value equal to the number of shares granted.
Tandem SARs is the common name for these options, which are typically granted in conjunction with stock options. They’re always at risk of being vested. As a result of SARs, the stock options can be purchased, and any outstanding taxes owed can be paid. There are various ways to use it to construct an attractive pay package, and it is very versatile.
Restricted Stock Unit (RSU)
RSU is one of the many equity awards that grant stock in a lump payment but are subjected to vesting schedules. As a result, these stocks cannot be transferred or resold until their vesting dates.
Voting rights are not conferred until all of the company’s stockholders have fully vested their shares. RSUs are given to CEOs because their perceived worth is more significant than stock options that must be purchased. After they’ve vested, these are taxed at regular income tax rates.
Restricted Stock Awards (RSA)
RSAs, on the other hand, are similar to RSUs, except that the recipient enjoys voting rights from the date of the issuance. Although all shares will be awarded post-vesting, this does not prohibit shareholders from exercising their rights.
When the stakes are high and experienced business heads must be recruited to create the leadership team, this type of equity award is typically given to the first five employees of a startup. In order to avoid a hit-and-run situation, vesting schedules are implemented. Capital gains can be maximized with RSAs, which are taxed at the time of grant.
Other Stock-Based Awards
In addition to these four types of stock-based awards, two further types are occasionally employed:
Stock Purchase Plan
This is a common equity award plan among firms that just went public. A 15% tax-free discount on stock purchases is available to employees under this arrangement. After a large liquidity event, this is a wonderful way to keep staff informed of the company’s progress.
Phantom Stock
This sort of equity award is designated for the most senior executives and offers the value and rights of a shareholder but does not grant actual shares of the company. The executive is compensated for their achievements while receiving a cash bonus and avoiding future share dilution.
Unlike SARs, phantom stocks do not rely on stock appreciation; rather, they offer a significant value regardless of the stock’s current market value. Income from these sources is taxed as if it were a regular source of income.
Equity Awards Vesting Schedule
There is a vesting schedule for all equity awards that are given to employees. Vesting provides a safety net for employees who receive company stock. It is also a legal necessity when granting stock. The below context will explain how it works and its types.
How Does a Vesting Schedule Work?
Ownership of stock or the right to purchase shares can be granted on a set period known as a vesting schedule. It is usually decided by the founders and is legally binding. As part of most equity awards ‘cliff’ phases, recipients are only eligible for stock vesting once they’ve served a certain number of years in employment. With a one-year cliff, a typical vesting period lasts between four and six years. It is possible for an employee to lose their shares if they resign before certain deadlines have passed.
Immediate Vesting vs Graded Vesting vs Cliff vesting
A number of factors influence the design of vesting schedules. There is no one-size-fits-all schedule for everyone. In order for these schedules to function in the best interest of the company’s financial situation, they must also meet the demands of the employees. For best equity awards, there are three common vesting schedules:
- Immediate vesting: In this circumstance, there is no ‘cliff.’ On the whole, senior experts are hired with early vesting periods. When they join the company, they’ll receive a large portion of the company’s stock in exchange for their hard work.
- Gradual vesting: This is the most prevalent type of stock award vesting schedule that is given to employees. Stocks begin to vest in equal monthly increments after the one-year cliff and eventually reach 100% after four years of vesting.
- Cliff Vesting: Equity rewards are granted in one go, but only after the cliff period has ended. Typically, short-term service providers, like advisors, consultants, or strategic directors on the board, are included in this plan.
Provide Equity in a Startup
Employee equity is part of an employee’s compensation package. Employees that receive equity pay in the form of non-cash compensation are given a stake in the startup. There are a variety of equity compensation choices, including restricted stock, performance shares, and stock options. We’ll go into more depth about this below.
Why is it Important to Give Equity to Employees?
Mature organizations can afford to pay the finest employees in the industry, enticing cash incentives. There is no way for startups to do this. A startup uses equity as a medium of exchange since it has no other means of bridging this gap.
This is because startups have difficulty maintaining a steady flow of money in the early stages of their business. However, this is also the period when they require the greatest employees to join the company in order to establish and grow it. Hence, providing equity benefits for employees is very important.
How does Equity Granting Work?
One of the most acceptable ways to attract, motivate, and keep talented people is to offer them equity in the company. In both startups and established corporations, shareholders are more invested in the company, and their performance improves. An equity compensation plan has practically become the standard in the startup business.
- For New Hires: This grant is used to pay market-rate wages to hire additional employees.
- For Promotion: These awards are meant to recognize employees who have just been promoted. The recipient of a promotion grant should be able to perform at the level you would expect if you were hiring them for a new role today.
- For Outstanding Performance: In order to be eligible for these grants, which are given out once a year, your top 10% to 20% of employees must have performed exceptionally well last year. Individual performance awards should be equal to half of the salary you would pay that person today if you were to hire them. Non-executive directors must have access to this fund.
Conclusion
Businesses are built on the foundations of their employees. An entrepreneur’s main priority is to recognize their contributions and ensure that they are properly compensated. A good first step in this direction is to implement an employment equity program.
What’s best for your company’s growth and success will ultimately determine how much equity you grant to your employees.