Equity-based compensation: Overview, definition, and example
What is equity-based compensation?
Equity-based compensation is a form of employee compensation where the employee is given ownership interest in the company, usually in the form of company stock or stock options. This type of compensation aligns the interests of employees with those of the company’s shareholders, as employees benefit directly from the company's success and growth in the value of its stock.
Equity-based compensation is commonly used by startups, tech companies, and other organizations that may not have the financial resources to offer high salaries but want to attract and retain talented employees by offering the potential for future wealth through the company’s equity. The most common forms of equity-based compensation include stock options, restricted stock units (RSUs), stock grants, and employee stock purchase plans (ESPPs).
Why is equity-based compensation important?
Equity-based compensation is important because it provides several benefits both to employees and employers:
- Attracting and retaining talent: By offering equity, companies can attract employees who are motivated by the potential for financial gain if the company performs well. It also helps retain key employees, as they typically must stay with the company for a certain period (vesting period) to fully realize the benefits.
- Aligning interests: It aligns the interests of employees with the company’s long-term goals. Since employees become partial owners, they have a direct interest in the company’s success, which can drive productivity and commitment.
- Conserving cash: Equity-based compensation allows companies, especially startups and growing businesses, to conserve cash while still offering competitive compensation packages.
- Incentivizing performance: As the value of equity-based compensation depends on the company’s performance, it encourages employees to work toward the company’s success, knowing that they will directly benefit from its growth.
Understanding equity-based compensation through an example
Imagine a tech startup called "InnovateTech" offers its software developers a salary of $80,000 per year but also grants them stock options as part of their compensation package. These stock options give the employees the right to purchase shares of the company at a set price (say $10 per share) after a certain vesting period, usually 4 years.
If InnovateTech grows and its stock price rises to $50 per share over the next few years, the employees can exercise their stock options, buying shares at $10 each and potentially selling them for $50 each, making a profit. This provides employees with an opportunity for financial gain, aligning their goals with the company’s success.
In another example, a publicly traded company, "GlobalCorp," might offer its employees restricted stock units (RSUs). The RSUs are granted with a vesting schedule, meaning the employee will not own the stocks outright until they have worked for the company for a specific number of years. After the vesting period, the employee receives shares in the company. This form of equity-based compensation encourages long-term commitment, as employees need to remain with the company to fully benefit from their RSUs.
Example of equity-based compensation clause
Here’s an example of how an equity-based compensation clause might appear in an employment agreement:
"As part of your compensation package, you will be granted stock options to purchase [number] shares of [Company Name] common stock at an exercise price of $[price] per share. These options will vest over a four-year period, with 25% vesting after the first year and the remaining 75% vesting in equal monthly installments thereafter. You must remain employed by the Company to exercise these options, and the options will expire if not exercised within [expiration period] after your employment terminates."
Conclusion
Equity-based compensation is an important tool for companies, particularly those with limited cash flow or those seeking to align their employees' interests with company performance. By offering employees a stake in the company, equity-based compensation can increase motivation, enhance retention, and attract top talent. Whether in the form of stock options, restricted stock units, or other equity-based incentives, these programs can be highly effective in driving long-term growth and company success while providing employees with the potential for financial rewards as the company thrives.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.