Private companies can—and absolutely should—consider offering equity compensation plans to their employees.
Equity compensation is a type of variable compensation that gives workers a share of the company’s profits. These plans are designed to offer more the longer an employee stays with the company, therefore increasing retention. Workers also want to see high-quality benefits like equity compensation plans when they’re considering what company best fits their needs.
The following types of equity compensation plans are ones private companies should consider adding to their compensation packages.
1. Partnership Interest
Partnerships are relatively straightforward to set up compared to other business structures. Partnership interest refers to the amount of a company a person owns. For example, two partners might split the company 50/50, while another company might have a majority owner with 60% of the company and two partners owning 20% each.
Partnership interest is a good idea for startups needing capital to fund their ability to scale. Each partner can contribute money and share in the profits and losses as the company grows. Each partner must pay tax on the company’s profits according to their share of the business, even if they didn’t receive all of the profits they were entitled to.
However, as a company grows and brings on more employees, it will likely need to switch to an S corp or C corp to offer equity compensation plans to workers.
2. Nonqualified Stock Options
Usually, the easiest equity compensation plan for private companies to implement is nonqualified stock options (NSOs).
Nonqualified stock options are shares of the company an employee can choose to purchase for a set price, known as the grant price, at a later date. The allowed purchase date is usually based on a vesting schedule that varies with the amount of time an employee works for the company. Once an employee buys the stocks, they are free to hold onto them or sell them for the exercise price.
However, when an employee exercises their NSOs, any profit made between the grant price and the exercise price is considered income that they’ll need to pay taxes on. The income is also subject to tax withholding.
Although the tax implications of NSOs can be a disadvantage for employees, employers typically have an easier time managing nonqualified stock options because they only have to calculate taxes on the profit made during the sale of shares. This contrasts the taxes involved in incentive stock options (ISOs), which I’ll speak about in the next section.
Employers can also use NSOs to supplement an employee’s regular pay without paying actual cash. Additionally, this equity compensation is available to independent contractors, allowing companies to incentivize the contractors they work with.
Employees can also benefit from this, as it’s an additional benefit they receive for their work that, over time, could grow into a lucrative nest egg. Employees can choose when to exercise their options so they can hang onto them as the company grows, potentially selling them for a much higher price than they originally bought them for.
3. Incentive Stock Options
ISOs are another common type of equity compensation for private companies that isn’t too complicated to set up.
ISOs work similarly to NSOs in that they are offered to employees to buy at a later date for a specific price on a vesting schedule. In most cases, employers typically require employees to work with the company for at least three years before they have the opportunity to buy shares, although some organizations may require shorter or longer periods.
Once the vesting schedule is up, employees can choose whether to exercise their stock options. At this point, the shares could be below or above fair market value. However, ISOs expire after 10 years, so employees must decide whether to exercise their options within this period.
To receive the full benefits of ISOs, an employee must hold their stocks for at least two years from the grant and at least one year from the date they exercise their stock options. As a result, they won’t have to pay tax on any profit they make from selling their stocks.
That’s why ISOs are generally more favored by employees than NSOs. However, to have those tax benefits, employees need to hold onto their stocks for longer than they would NSOs, which can be a disadvantage to employees who may not be looking for longevity within the company.
Conversely, companies seeking longevity from employees—for example, smaller companies looking to expand with a core group of workers—usually choose ISOs over NSOs because they act as a long-term incentive.
4. Stock Appreciation Rights
Stock appreciation rights (SARs) provide employees with profits based on the appreciation of shares.
For example, say an employee was given 50 SARs for $50 each. After the vesting period, the stocks rose to $75, for an appreciation of $25 each, or $1,250 in total for 50 SARs. That employee would earn an appreciation of $1,250.
The difference with SARs compared to other forms of equity compensation is that employees don’t need to pay for the shares to start with. Instead, the company grants them, and the employee simply earns the profit. However, that profit becomes taxed as income.
Companies usually offer SARs when they’re just starting out and don’t have a significant amount of cash flow coming in. Rather than pay out cash bonuses with a limited budget, companies can consider SARs as a viable alternative that motivates employees with the potential for future profits.
5. Restricted Stock Units
Private companies looking to beef up their executive compensation packages might choose restricted stock units, or RSUs.
Private companies provide RSUs to workers, which hold no value until they’re vested, encouraging employees to stay with the company for at least that period. RSUs are typically given as a dollar amount, say $25,000. When vested, they transform into actual shares based on the company’s share value at the time the RSU was given.
So, an employee with $25,000 in RSUs for a company with stocks worth $25 per share gets 1,000 shares once their RSUs have vested.
RSUs can use graded or cliff vesting. Graded vesting stretches the vesting period over a set number of years, each year releasing a portion of the shares to the employee. Using the example above, an employee might receive 20% of their shares over five years, or 200 shares per year.
With cliff vesting, the employee receives all shares at one time after a specific period, usually 3-5 years.
RSUs are often reserved for top executives because they can be extremely profitable as a company grows. Plus, the vesting schedule encourages employees to commit to the company for long terms, which is exactly what companies want from executives.
6. Employee Stock Purchase Plans
Employee stock purchase plans (ESPPs) let employees contribute a portion of their paychecks toward buying shares of the company. Think of it like a 401k, through which an employee has payroll deductions going directly to their retirement fund, but with the goal of stock purchases rather than retirement savings.
Shares bought through ESPPs are priced at the lowest amount for that purchasing period, allowing employees to get their hands on stocks for a lower cost than they might have otherwise. By contributing regular portions of their paychecks, they can continue to build their nest egg of stocks, which could eventually sell for a much higher price.
Although employees don’t pay taxes when they buy shares, they do have to pay taxes on the share discount they receive when purchasing shares when they decide to sell their shares if using a qualified ESPP. The rest of the profits get taxed as capital gains.
With a nonqualified ESPP, the full profit earned from an ESPP is taxed as income. Still, it might not be too worrisome, as employees stand to gain a good amount of money when selling shares of a growing company.
It’s also important to note that the IRS caps the amount of shares an employee can purchase per year at $25,000.
On the business side of things, ESPPs can boost retention and talent acquisition. It is also a relatively inexpensive benefit to implement that has potentially lucrative results for employees.
However, ESPPs can be complicated for companies in terms of taxes. Nonqualified ESPPs are generally less cumbersome to deal with, but they result in higher taxes for employees. If you want to offer employees the best version, qualified ESPPs take the cake, but the company will need to deal with more complex accounting.
Choosing the Right Equity Compensation Plan
While partnership interest is probably the easiest choice for startups to split equity among two or more business owners, growing companies will need an equity compensation plan that gives workers a piece of the pie, too.
NSOs and ISOs are among the most popular options for their relatively easy setup and maintenance and their ability to motivate workers toward reaching long-term company goals. Still, other equity compensation, like SARs, RSUs, and ESPPs, are equally as excellent for employee retention, although they may require a bit more accounting to maintain.
As your business grows, you might even see the need to switch equity compensation plans. Consider getting help from a financial advisor before implementing equity compensation to determine the best path for the company’s current and future needs.
