In today’s competitive marketplace of business, equity awards have become a grand tool for companies to attract, retain, and incentivize employees and other key stakeholders. Generally, an equity award is part of a compensation package. It grants the recipient ownership in a company and thereby aligns their interests with the success of the company. What exactly is it, though?
This in-depth guide will analyze equity awards: how they work, their types, and their importance in today’s corporate world.
Understanding Equity Awards
Equity awards refer to the mechanism of compensation through which a firm provides employees or other stakeholders with ownership in the firm. Such ownership is represented in different forms but serves to reward employees financially, relating to the fortunes of the company.
Unlike traditional forms of compensation, such as salary or bonuses, equity awards are typically connected to stock options, shares, or other securities that increase in value according to the company’s performance.
Why is Equity Award Important?
Equity award can serve different purposes. Some of these purposes include:
- To attract a top talent: Companies operating in highly competitive markets could utilize an equity award to encourage better-skilled staff.
- Retention: Such employees will stay within the company to enjoy a stake at its long-run.
- Motivation: Whenever the employee in the organization holds some stocks, there must be the motivation of creating profits for the company
- Equating of Interests: Equity awards go as far as equating the interest of the employees, executives, and shareholders to make them all work on the same goal.
Types of Equity Awards
There are a number of different kinds of equity awards that can be granted. The most frequently granted forms include:
1. Stock Options
Stock options grant an employee a right to purchase a designated number of shares of company stock at a predetermined price, known as the exercise price or strike price. They are usually issued with vesting-programs, or time periods when the employee is required to retain employment with the firm before exercising the option.
There are two primary forms of stock options:
- Incentive Stock Options (ISOs): Generally granted to employees, ISOs offer favorable tax treatment.
- Non-Qualified Stock Options (NSOs): Available for issuance to employees, directors, and consultants who are brought in from the outside, NSOs are taxed as ordinary income when exercised.
2. Restricted Stock Units (RSUs)
RSUs are company shares issued to employees, however, it does not necessarily vest right away. Shares must be “earned” by the employee for the company’s fulfillment of specified conditions, including but not limited to working for the company for a certain period of time or accomplishing predetermined performance thresholds. RSUs are considered not as risky because these have value upon vesting.
3. Performance Shares
Performance shares are share grants that only vest as performance-based targets granted by companies or individuals are achieved. Usually, it is given to executives or other employees who are deemed important to the company. Rewards are tied to measurable results, such as revenue growth, profit margins, or performance of the company’s stock price. The more targets achieved, the more shares that the employee receives.
4. Employee Stock Purchase Plans (ESPPs)
An ESPP is a type of employee benefit plan where the company provides the common stock of the company to the employees at a discounted price. The discount percentage can range from 5% to 15%; however, it remains that attractive for employees to invest in their companies. The benefits received are tax-favored and, in most cases, participation is voluntary.
5. Stock Appreciation Rights (SARs)
SARs are basically the same as stock options except that the employees do not have to purchase stock. Instead, they are paid the monetary equivalent of the gain in the price of the stock over a specific time. Such an award would be useful for companies that want equity-like compensation without diluting their stock.
How Do Equity Awards Work?
In most cases, equity awards come with a vesting schedule. Vesting schedules determine when the employees can fully own the award. Generally, vesting ensures that the employees stay with the company for a given period before they actually get to exercise their equity rights. The vesting schedule could either be time-based or performance-based.
- Time-based vesting: The employee earns an ownership of the equity over a set period. Normally, this period is three to five years.
- Performance-based vesting: Vested not on grant date but on performance criteria, say revenue growth or profitability targets. This means the employee can only become fully vested when he manages to meet the defined performance metrics, be it a certain benchmark for profitability or revenue growth.
Following vesting, an employee can either sell the shares or hold them, based on market conditions and an overall financial plan.
Tax Effects of Grants and Awards
Taxation is part of the stock equity awards, and employees need to know what the possible tax implications are. The tax treatment varies between different types of awards:
- Stock Options: ISOs are typically tax-favorable. They don’t have tax implications when exercised if certain conditions are met. NSOs are taxed as ordinary income at the time of exercising.
- RSUs: Any portion of the shares is taxed as ordinary income if it vests.
- Performance Shares: Any portion of those shares is taxed as ordinary income once the performance criteria are met and they vest.
- ESPPs: Employees generally get favorable tax treatment if they meet the holding requirements.
- SARs: Appreciation is treated as ordinary income when the award is exercised.
Employees should talk to a tax advisor about how, in total, their equity awards are going to work out for them.
Equity Awards for Executives and Employees
While executive equity awards are probably the most well-known type, companies increasingly grant equity awards to employees at all levels. Even so, the equity compensation structure is typically distinct between executives and non-executive employees.
- Executives: Generally, they get a mix of stock options, performance shares, and RSUs that are more closely related to company and shareholder performance.
- Employees: Apparently, for them to have more chance of receiving RSUs or participating in an ESPP as the risks are relatively low but this brings more useful ownership incentives.
Executives are generally exposed to a greater percentage of their pay tied to equity-which binds executives to company performance. This, thus underscores their ability to improve the performance of the company.
Equity Awards Advantages and Disadvantages
Advantages of Equity Awards: There are quite a number of advantages related to equity awards; however, there are several inherent risks also.
Advantages:
- Alignment of Interest: It is likely that the employee will make decisions which improve the long-run prosperity of the company.
- Increased Motivation: The possibility of the upside in equity finally motivates employees to do their best at the top levels.
- Retention: The vesting schedule continues to motivate retention by the vesting periods that arise as a result of the award.
- Tax Benefits: There is some sort of tax preferences pertaining to certain types of equity awards
Disadvantages
- Stock Price Volatility: The wealth of employees is, in part, dependent upon the company’s stock price, and the latter would fluctuate with respect to market conditions.
- Dilution: Employees receive new shares, and it can dilute the ownership rights of other existing shareholders.
- Complex Taxation: Employees face complex rules that would cover taxation; sometimes these rules depend upon the nature of the equity award made as well as the timing of transactions.
Conclusion
In today’s compensation strategy, equity awards work to align the interests of employees and shareholders with long-term growth incentives. Therefore, a good understanding of how equity awards work, their forms, and their tax implications is important to both the employer and the employee.
Equity awards can be used to attract any employee and retain key personnel; they can motivate the workforce toward greater success for the company.