Equity compensation is a non-cash form of payment that’s popular in many companies, from early-stage startups to established enterprises. Equity compensation plans offer flexibility to companies while providing additional incentives to employees beyond the standard salary and cash bonuses.
A 2020 survey of equity compensation participants by Charles Schwab indicates that this type of benefit is an increasingly important factor in employment decisions.
The idea behind equity-based compensation is to give employees a “piece of the pie”—a bit of ownership (or ownership-like benefits) in the company. In other words, employees benefit directly from the company’s growth and success.
It’s a powerful and flexible tool to recruit top talent, encourage employee retention, and reward key employees.
Types of Equity Compensation: Stock Options Aren’t the Only Way
Most people associate equity compensation with company stock. And certainly, stock options or other stock-based compensation are some of the more popular ways to reward employees beyond cash.
However, stock option plans come with some drawbacks:
- Depending on your business structure, you may not actually have stock to offer.
- Awarding stock or other forms of equity means awarding company ownership. If founders give away too much, they may dilute their own control and future profits.
- Awarding too much ownership in your company’s early stages can also turn off future investors.
- Equity, or ownership, can come with obligations and risks on the part of the employee who receives the equity. Not all employees want that level of responsibility, but they do want financial rewards for great service and loyalty to the company.
Below are 4 popular alternatives to stock-based compensation. Each option offers a great deal of flexibility in how the agreement can be structured. Keep in mind that each of these has unique tax implications for both businesses and employees, so be sure to consult a professional before diving in!
Profit Pool
A profit pool is one of the simplest versions of a long-term incentive plan. The company decides on a percentage of annual profits to add to a pool for participating employees. (The company can set a minimum profit threshold to avoid losing money on this set up.)
Then, the profit pool is split between participating employees according to the formula the company’s management decides to use. The company may also decide when to pay out profits and how much of the pool to distribute at once.
The earnings from a profit pool are considered accumulated earnings or retained earnings, normally taxable upon payout. Be sure to discuss your tax setup with a professional!
Phantom Stocks or Synthetic Equity
Phantom stocks, which are sometimes referred to as synthetic equity, offer very similar financial rewards to stock based compensation. Employees can be financially rewarded as the company increases in value, but they do not receive any ownership rights. They also don’t have to pay for the “stock” to earn profits from it. Read our post on phantom stock plans to learn more about how they work and the different plan options.
Stock Appreciation Rights
Stock appreciation rights (SARs) are very similar to phantom stocks. The key differences are when and how the value can be cashed out, with SARs offering more flexibility. However, earnings from SARs may sometimes be less favorable from a tax perspective.
Profits Interest
A profits interest agreement is a form of equity-based compensation that typically grants a limited level of company ownership to the recipient. The recipient of a profits interest is granted a portion of company profits, but (in most cases) does not get voting rights or all of the tax benefits that typically come with equity.
Need Help with Equity Compensation Plans?
Our business attorneys have helped countless companies design custom equity compensation plans, using stock based compensation, stock options, and alternative methods.
We’ll help you navigate your options and design the plan that fits your exact needs. Call today to schedule a confidential consultation!
