In today’s ongoing war for talent, employee equity is becoming a key element of many companies’ compensation packages. Whether you’re working at a start-up or a large corporation, employee equity offers an opportunity to own a part of the business that you help build. But what exactly is employee equity and how does it work? And what are the benefits and risks and what should you consider before participating in an equity plan.
What is Employee Equity?
Employee equity refers to a company offering its employee’s ownership stakes in the business through shares or stock options. This is often done as part of a broader compensation package, alongside salary and bonuses. By granting equity, companies are hoping to align employees’ financial incentives with the company’s performance, and hoping that employees feel they have a personal stake in the business’s success.
The concept of employee equity is most common in start-ups and high-growth tech companies. These companies often can’t compete with larger firms on salary alone, so equity offers a way to make up for a lower salary in by providing a long-term financial upside. It’s also widely used by established firms to retain top talent and encourage long-term commitment.
Types of Employee Equity
1. Stock Options
- How it works: Employees are given the option to buy company shares at a predetermined price (called the “exercise price” or “strike price”) after a set period (the “vesting period”). If the company’s stock value increases, employees can buy shares at the lower exercise price and sell them for a profit.
- Why it matters: Stock options are popular because they offer significant upside if the company grows in value. However, they come with the risk that if the company’s stock price declines or fails to increase, the options may become worthless.
2. Restricted Stock Units (RSUs)
- How it works: RSUs are a form of equity where employees are granted shares as part of their compensation. These shares vest over time, meaning employees receive the stock after meeting certain time or performance conditions.
- Benefits: Unlike stock options, RSUs have value even if the stock price drops, as employees own the shares outright once they vest. RSUs are typically used by larger, established companies.
3. Employee Stock Purchase Plans (ESPPs)
- How it works: ESPPs allow employees to buy company stock at a discounted price, often through payroll deductions. These plans offer a direct way for employees to invest in the company they work for.
- Why it matters: ESPPs can be a valuable way for employees to build wealth, especially when they’re able to purchase stock at a discount and potentially sell it at a higher market value.
4. Equity Incentive Plans
- How it works: These are broad plans that include various types of equity awards, such as options or RSUs, given to employees as part of their total compensation. These plans often include performance-based equity, where shares are awarded based on company or individual performance.
- Benefits: These plans reward long-term contributions and performance, encouraging employees to stay with the company and work toward shared goals.
Key Considerations for Employees
While employee equity can be highly rewarding, it’s essential to understand the details and potential risks involved before jumping in. Here are a few key factors to consider:
1. Vesting Period
- Most equity awards come with a vesting period, which means you don’t receive the full benefits right away. Typically, you’ll need to stay with the company for a few years to fully own your equity. A common vesting schedule is 4 years with a 1-year cliff, meaning you need to stay at least 1 year to start earning your equity.
2. Tax Implications
- Equity compensation can have significant tax consequences. For example, when you exercise stock options, you may owe taxes based on the difference between the exercise price and the fair market value. RSUs are taxed when they vest, often as ordinary income. It’s important to understand how your equity is taxed and consider working with a tax advisor.
3. Risk of Stock Price Volatility
- The value of your equity depends on the company’s stock price. While equity offers potential for significant gains, it also comes with the risk that the company’s stock price could drop or fail to grow. If the stock price falls below your option’s exercise price, those options could become worthless.
4. Liquidity
- In many cases, employees cannot sell their shares right away, particularly in private companies. You may need to wait for a liquidity event, such as the company going public or being acquired, to sell your shares and realize the financial benefits.
5. Equity vs. Salary
- Equity compensation should be considered part of your overall compensation package, but it’s important to balance equity with your salary. While equity has the potential for large rewards, it doesn’t provide immediate income for day-to-day expenses.
6. Risk of Lack of Diversification
- Having all your eggs in one basket isn’t the best approach for building wealth. Having too much stock in one company means you can be over-exposed to the fortunes of one company so consider reducing this exposure by systematically divesting yourself of these shares once you can do so without restriction and then consider re-investing any proceeds of sale into a diversified fund.
How to Maximize Employee Equity
- Understand Your Equity Offer: Ask questions to ensure you understand the type of equity you’re being offered, the vesting schedule, and any conditions tied to it.
- Stay for the Vesting: If possible, aim to stay at your company long enough to maximise your equity awards. Leaving before you’ve fully vested could mean missing out on valuable compensation.
- Diversify Your Investments: While equity in your company is an exciting opportunity, it’s important not to rely too heavily on one asset. Diversify your investments to protect your financial future in case the company’s stock doesn’t perform as expected.
Conclusion
Employee equity can offer a powerful way for employees to participate in the financial success of the companies they help build. However, it’s important to understand the specifics of your equity plan, including vesting schedules, tax implications, and potential risks.
At Women’s Wealth we know equity compensation can be complex and we are always happy to help you make informed decisions and maximise the value of your equity.
