The Pros & Cons of Equity Compensation for Employees
What is Equity Compensation?
Equity compensation is non-cash pay that represents ownership in the company. This type of compensation can take many forms, including options, restricted stock, and performance shares.[1]
Types of Equity Compensation:
Stock Options
Stock options allow an employee to purchase shares at a pre-determined price during a specific period of time. Standard agreements will stipulate when the option “vests,” and create a window of time when the purchase can take place, also called the “exercise period.” [2]
2. Restricted Stock Units (RSUs)
Restricted Stock Units are restricted because they are promised to a particular party and can’t be sold until they have vested. This is different than a Stock Option, which simply creates the right to purchase shares at set rate, without any commitment from either party. RSU’s are granted to an employee, rather than sold. Once vested, RSU’s are just like any other shares of company stock.
3. Performance Shares
Performance shares are similar to RSUs for the fact that they can’t be sold until a certain condition has been met. In this case, the condition that has to be met is based on an employee’s performance rather than a timeline. Performance is often assessed and determined through the use of common metrics like Earnings per Share (EPS), return on equity (ROE), or the company’s total performance in relation to an index.
What are the Benefits of Equity Compensation?
1. Cash Conservation
For companies that are just starting out, attracting top talent can be difficult when you can’t match the high salaries offered by your competitors. As an alternative, start-ups can offer equity packages to supplement the employees’ wages. This allows you to offer competitive employment opportunities while maintaining the cashflow of the company.
2. Encourages Performance
Employees are more likely to take charge of their role and performance when they can reap a direct benefit from the growth of the company. Their success at work translates directly to their personal financial success. Additionally, if the employee feels like a part-owner in the company, this will empower them to take a proactive role in ensuring the success of business overall.
3. Improves Employee Retention
Equity agreements also strengthen the relationship between the employees and the employer. Employees with equity feel more connected to the company than just regularly salaried workers because they have an additional stake in the company. This, in itself, can lead to better retention because the employees develop a sense of attachment. When coupled with a vesting schedule that rewards long-term commitments, this can be an especially effective method of retaining talent.
What are the Drawbacks of Equity Compensation?
1. Tax Complications
The biggest drawback of equity compensation is that it can lead to overly complicated tax scenarios:
In some instances, it can be difficult to ascertain the true owner of a share when it is left in ‘limbo’ by the vesting schedule or vesting conditions. The share may be allocated to an employee, but can’t be owned officially until some pre-requisite is satisfied.
Laws governing the taxation of employee share-options also tend to be intricate and complex. In Canada, for instance, it was recently proposed that there should be a $200,000 annual vesting limit for employees receiving stock options after 2019. Preeminent firms like BDO and Osler are now commenting on the implications of this new limit for employers. [3] [4]
2. Loss of Ownership
A more obvious disadvantage of equity compensation plans is that the owner has to relinquish some of their share in the company. The fewer shares that are issued to employees, the more profit goes directly to the owner.
3. Corporate Governance Issues
Although employee equity agreements are usually based on shares without any voting privileges, this doesn’t have to be the case every time. If voting privileges are included in the shareholders rights, this can lead to problems of corporate governance. The original owner of the business can lose control if too many people have a say in the management of the company, and runs the risk of he or she being outvoted.
4. Employee Morale
Although the benefits employee retention were discussed above, the other side of the coin is that equity agreements can sometimes lead an employee to feel trapped. Just as the success of the company might encourage employees’ strong performance, company losses can also take a toll on employee morale. Having to wait until their shares are vested may put a negative pressure on the employee to stay with the company, and come to feel like a lack of exit opportunities.
[1] https://www.investopedia.com/terms/e/equity-compensation.asp#:~:text=Equity%20compensation%20is%20non%2Dcash,represents%20ownership%20in%20the%20firm.&text=Equity%20compensation%20allows%20the%20employees,if%20there%20are%20vesting%20requirements.
[2] https://ca.practicallaw.thomsonreuters.com/Document/I75daf3a62f0a11e798dc8b09b4f043e0/View/FullText.html?transitionType=SearchItem&contextData=(sc.Search)&OWSessionId=bd7bca120e79423ba8a60edda7b4de17&skipAnonymous=true&firstPage=true
[3] https://www.bdo.ca/en-ca/insights/tax/tax-alerts/stock-option-taxation-proposed-changes/
[4] https://www.osler.com/en/resources/regulations/2019/canadian-government-introduces-tax-legislation-applying-to-employee-stock-options-granted-on-or-afte