The Basics of Equity Compensation

Introduction

Millions of employees have or have a right to company equity as part of their compensation package. Equity is offered to executives as a way of tying pay to performance. Other employees receive equity to give them a stake in the company, so they are motivated to contribute to its success. Equity compensation is also used by companies to reduce the amount of cash they need to pay employees. This is particularly true for high growth startup companies that do not have a lot of cash.

Equity compensation comes in different forms:

• Stock Options
• Restricted Stock
• Restricted Stock Units
• Stock Appreciation Rights
• Phantom Stock
• Employee Stock Purchase Plans

We will look at each of these in greater detail later in the course.

Employees at different levels of the organization may receive different kinds of equity packages:

1. For rank-and-file employees, an employee stock purchase plan or restricted stock units would be an appropriate offering.
2. Senior-level employees may get a combination of restricted stock and more at-risk performance-based equity compensation.
3. Senior executives could receive a mix of time- and performance-based equity compensation that is at risk and tied to company performance, such as stock options and stock appreciation rights.

Trends

In the early 1990s, stock options gained popularity as a “low cost” form of compensation that had favorable accounting treatment. Toward the end of the decade, approximately 75% of long-term equity awards were stock options. However, a series of events, beginning in 2006 with a change in accounting rules that now require a grant of options to be charged against earnings, the stock market crash in 2008 with an extended recovery, and the 2010 Dodd-Frank Act say-on-pay requirement for executive compensation, have made stock options less popular. Today, only about 25% of all long-term equity awards are stock options. Many established organizations have shifted to other kinds of equity awards such as restricted stock.

Starting in 2018, under the Tax Cuts and Jobs Act, all performance-based compensation became subject to the $1 million limit on employer deductibility (Section 162(m)). This change has the greatest impact on Non-qualified Stock Options (NSOs) because prior to 2018 they were not covered by the deductibility limit, and they do not have the same preferential tax treatment (hence non-qualified) as Incentive Stock Options (ISOs).

Restricted Stock or Restricted Stock Units, while not offering the big potential gains in wealth that stock options offer, will continue to gain in popularity because they are less affected by volatility in the stock market.