Offering equity in a company can be attractive to candidates and employers alike. When an employer provides equity to an employee or candidate for employment, they are giving you some ownership in the company. Private companies including startups, as well as public companies, can provide equity.
The most common methods of equity are:
- Stock Options: You give employees the opportunity to buy or sell a specific number or percentage of shares at an agreed-upon strike price if the company goes public, is acquired, or they leave the company and want to sell their stock back.
- Stock Grants: Stock grants are like stock options except you’re giving the employees the stock (i.e., they do not need to buy it from the company). The value of the stock is whatever the market value is at the time the company goes public or is acquired.
Below are key considerations if equity is part of an employee’s job offer or compensation package.
The Benefits of Offering Equity
When public companies furnish stock options and grants there is already a monetary value. If the company is private, stock options and grants don’t have a monetary value yet but could be worth money in the future. Here are the main reasons an employer may want to offer equity at this stage:
1. Pay Lower Salaries
When an employer offers equity compensation, candidates may be willing to work for a lower salary if they believe they’ll earn a future windfall if the company succeeds. Instead of paying large salaries, an employer can hire more employees at a lower rate.
2. Recruit Top Talent
A company cannot attract top talent if they are offering a salary that is lower than the market. Offering equity can incentivize candidates to join the company at a lower salary.
3. Increase Retention
Business owners often use equity compensation to increase employee retention by requiring employees to remain with the company at least until their stock vests. The vesting date is when employees officially own the stock (and can sell it at that time).
Many companies have a four-year vesting schedule with a one-year cliff. This means new employees don’t receive equity until they reach one year of service. After that, they receive a percentage every year. For example, an employee might get 25 percent each year. If an employee leaves before it all vests, they still own the amount that already vested.
4. Drive Employee Engagement
When employees have ownership in the company, they are likely to have higher levels of engagement since they will have more of a stake in the company’s success. Companies with high levels of employee engagement are often more successful.
The Potential Disadvantages of Providing Equity
While there are benefits to offering equity compensation, there are possible downsides.
1. Complexity
When a company is in the early stages, it can be hard to predict the valuation of the company in order to set a fair strike price. To incentivize employees to remain with the company, the strike price should be lower than the market value so employees will realize a “discount”. (If it’s higher than the market rate, it is meaningless because employees can buy shares at the lower price).
It can be easier to furnish a stock grant, also known as a restricted stock unit (RSU), because companies don’t need to anticipate the market rate. The stock will be worth whatever it is worth when the company goes public or is sold or acquired.
Finally, stock options and stock grants are taxed differently, which causes some of the complexity with this type of compensation.
2. Less Ownership in Your Company
A Founder or CEO gives away some of his/her ownership to employees when equity is handed out. The company would earn less money from an acquisition or going public because they would hold fewer shares.
How to Offer Equity
Here are the steps to take if a company decides to offer equity.
1. Create an Employee Option Pool
A company should identify how much equity should be reserved for employees. As a company hires employees, it can see how many shares remain and whether the company will need to dilute some of the shares to add more to the pool.
2. Decide the Type of Stock and Amount
Companies should also determine whether to offer stock options or stock grants, and common or preferred stock. To determine how much equity compensation to give each employee, companies should consider the employee’s seniority and criticality to the success of the company.
In Conclusion
Offering equity compensation to employees can help hire a team for less “cash”, attract and retain talent, and increase employee engagement. Companies of all sizes should consider this type of compensation as part of their toolkit.