Equity compensation: How types work, pros and cons

Equity compensation has become a cornerstone of modern compensation packages, with research showing more than one-fifth of U.S. private-sector employees owning company stock. It is particularly prevalent in startups and growth-stage companies looking to attract and retain top talent. But what exactly does it mean to receive stock options or restricted stock units as part of your pay? And for employers, when does offering ownership stakes make strategic sense?

This guide breaks down everything you need to know about equity compensation—from understanding different types and how they work, to weighing the benefits against potential drawbacks. Whether you're an HR leader designing compensation packages or an employee evaluating an equity offer, you'll find practical insights to help you make informed decisions.

What is equity compensation?

Equity compensation gives employees ownership stakes in their company instead of just cash payments. Common forms include stock options, restricted stock units, and employee stock purchase plans (ESPPs).

The value of equity compensation is tied to the company's performance. When the company does well and meets its targets, the value of the ownership increases, and vice versa. 

How equity compensation works

Understanding equity compensation involves a few key stages, from receiving the offer to potentially cashing it in. While the specifics depend on the type of equity, the general lifecycle follows a clear path.

So how does this work in practice? The process follows four key stages:

• Grant: Your company offers you the right to future ownership, specifying shares and terms.

• Vesting: You earn the right to your shares over time or by meeting performance goals.

• Exercise: For stock options, you buy the shares at your predetermined "strike price."

• Sale: You sell your shares when the market price exceeds what you paid.

Common types of equity compensation 

Some of the most common types of equity compensation include:

• Stock Options: Employees have the option—but not the obligation—to purchase shares of the company stock at a predetermined price.

• Employee Stock Purchase Plan (ESPP): Employees can opt to purchase company stock at a discount price at set intervals via a payroll deduction. These plans often have tax advantages.

• Virtual or Phantom Stock: Employees purchase portions of shares of the company and receive a payout of their value at a predetermined point, but don't actually have any ownership of the company or the rights and privileges of a shareholder.

• Series B Equity Compensation: These options are awarded after a startup has completed its Series A funding, started acting on its business model and strategy, and demonstrated that its strategy is working. Funding may come from the initial investors or a new set of Series B investors. 

• Restricted Stock: This form of equity compensation is relatively rare. Essentially, it's stock granted in the very early stages of a company to entice talent or investors, but there's usually little or no market for it. Restricted stocks have limited value and significant tax implications, so they tend to be a good faith promise to individuals to stay with the company in the early stages. 

Vesting schedules and restrictions

Equity isn't granted all at once. A vesting schedule acts as a timeline for earning full ownership of your shares, encouraging long-term commitment. If you leave the company before you are fully vested, you typically forfeit the unvested portion, and according to the U.S. Bureau of Labor Statistics, a typical vesting requirement is five years of service.

Common vesting schedules include:

• Cliff Vesting: This requires an employee to work for a specific period—often one year—before any equity becomes theirs. After this "cliff," they might receive a large chunk of their shares at once.

• Graded Vesting: With this model, you earn your shares in smaller increments over a longer period. For example, after a one-year cliff, you might vest a portion of your remaining shares every month or quarter for the next three years.

Other restrictions can also apply, such as holding periods that require you to wait a certain amount of time after exercising your options before you can sell the shares.

Benefits of equity compensation

What makes equity compensation appealing to both companies and employees? Here are the key advantages:

• Cash flow management: Startups can attract top talent without straining their budget by offering future ownership instead of higher salaries upfront.

• Higher engagement: When employees own a piece of the company, they're naturally more invested in its success, which can lead to an average 4 to 5 percent gain in productivity.

• Talent attraction and retention: The potential for wealth building keeps top performers interested and loyal. Supporting this, a 2023 analysis found that companies with ESPPs won twice as many awards as a "best place to work" than those without.

• Long-term commitment: Vesting schedules encourage employees to stay and contribute to long-term growth.

Drawbacks of equity compensation 

But equity compensation isn't perfect. Here are the main challenges to consider:

• Misaligned priorities: Employees might focus on short-term gains rather than long-term company success, especially if they're not willing to wait as long for returns as traditional shareholders.

• Dilution of ownership: Offering all employees the option to own company shares can reduce the value of individual shares and the earnings per share. It can also reduce the control that existing or long-term shareholders have over the company.

• Limited appeal: Equity compensation plans aren't necessarily appealing to all employees. Although typically a welcome benefit in the C-suite, where employees earn higher salaries, other employees may not find the option as valuable and prefer cash over equity compensation.

• Accounting complexity: Managing an equity compensation plan is complex and can create accounting challenges, with SEC commenters noting that disclosure rules can lead to additional printing costs of $100,000 and mailing costs of $200,000.

Tax implications of equity compensation

Here's the tricky part: taxes. The rules vary significantly based on several factors:

• Type of equity: Stock options, RSUs, and ESPPs are taxed differently

• Timing: When you exercise, vest, or sell affects your tax bill

• Location: Tax laws vary by country and state

For example, while some stock option profits are taxed as ordinary income, the IRS states that for statutory stock options, you generally don't include any amount in gross income upon receipt or exercise, though other tax rules may apply. Always consult a tax professional for your specific situation.

Managing equity compensation globally

Offering equity is a powerful way to build a team of owners, but doing so across borders adds another layer of complexity. Each country has its own rules around taxation, securities laws, and reporting requirements, making it a challenge for companies to offer fair and compliant plans to a distributed workforce.

A global employment platform can help you navigate these challenges. Oyster's Total Rewards solution includes an Equity Assessment Tool that helps you understand feasibility and compliance in over 80 countries, so you can design competitive and equitable compensation packages for your entire team. Whether you're looking to attract top talent or retain key employees, you can start hiring globally with confidence.

FAQs

What is an example of equity compensation?

Stock options are the most common example—you might get the right to buy 1,000 company shares at $5 each, then profit by selling them at a higher market price later.

Does equity compensation count as income?

Yes, equity compensation is typically taxed as income when you exercise options or when shares vest. Your employer usually reports this on your W-2 and withholds taxes accordingly.

Is equity compensation worth it?

It depends on the company's success and your risk tolerance. Equity can create significant wealth if the company grows, but it's worthless if the company fails.