Please read the full disclaimer and seek professional advice from a lawyer, tax professional, or other compensation expert before making significant decisions. Does that make reading through these details a waste of time? Not at all. Important decisions rarely should or can be blindly delegated. This Guide complements but does not replace the advice you get from professionals. Working with the support of a professional can help you make better decisions when you have an understanding of the topic yourself and know what questions to ask.
Companies ranging from two-person startups to the Fortune have found that granting partial ownership in a company is among the best methods to attract and retain exceptional talent. In the United States, partial ownership through stock options has been a key part of pay for executives and other employees since the s.
Public companies offer executives equity compensation in no small part because of a tax loophole.
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Unfortunately, the legislation backfired; a loophole made performance-based pay—including stock options—fully tax deductible, thereby creating a dramatic incentive to pay executives through stock options. Generally, equity compensation is closely linked to the growth of a company. Cash-poor startups persuade early employees to take pay cuts and join their team by offering meaningful ownerships stakes , catering to hopes that the company will one day grow large enough to go public or be sold for an ample sum.
More mature but still fast-growing companies find offering compensation linked to ownership is more attractive than high cash compensation to many candidates.
How are These Awards Taxed?
With the hope for growth, however, also comes risk. Large, fast-growing companies often hit hard times. And startups routinely fail or yield no returns for investors or workers.
Compensation comes in the forms of cash pay salary and any bonuses and any non-cash pay, including benefits like health insurance, family-related protections, perks, and retirement plans. Company strategies for compensation are far from simple. Beth Scheer, head of talent at the venture fund Homebrew, offers a thoughtful overview of compensation in startups.
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Another term you may encounter is total rewards , which refers to a model of attracting and retaining employees using a combination of salary and incentive compensation like equity , benefits, recognition for contribution or commitment like awards and bonuses , training programs, and initiatives to improve the work environment. One common kind of equity is stock, but equity can take other forms, such as stock options or warrants , that give ownership rights.
Commonly, equity also comes with certain conditions, such as vesting or repurchase rights. Note the term equity also has several other technical meanings in accounting and real estate. In this Guide we focus on equity compensation in stock corporations , the kind of company where ownership is represented by stock. We describe stock in more detail in the next section. Equity compensation in the form of a direct grant of stock with no strings attached is very rare. Instead, employees are given stock with additional restrictions placed on it, or are given contractual rights that later can lead to owning stock.
The purpose of equity compensation is threefold:. Attract and retain talent.
When a company already has or can be predicted to have significant financial success, talented people are incentivized to work for the company by the prospect of their equity being worth a lot of money in the future. But even a small chance at winning big can be worth the risk to many people, and to some the risk itself can be exciting.
Align incentives. Even companies that can afford to pay lots of cash may prefer to give employees equity, so that employees work to increase the future value of the company.
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It also encourages everyone involved to think long-term , which is key for company success. Reduce cash spending. By giving equity, a company can often pay less in cash compensation to employees now, with the hope of rewarding them later, and put that money toward other investments or operating expenses.
This can be essential in the early stages of a company or at other times where there may not be enough revenue to pay large salaries.
Top 10 Financial-Planning Rules That Everyone With Stock Options Needs To Know
Equity compensation can also help recruit senior employees or executives who would otherwise command especially high salaries. In this section, we describe the basics of how stock and shares are used. Those familiar with stock, stock corporations , public companies , and private companies can jump ahead to how those companies grant equity. In the United States, specific rules and regulations govern several kinds of business entities.
Federal and state law have significant implications on liability and taxation for each kind of company. Notable types of companies include sole proprietorships, partnerships, limited liability companies LLCs , S corporations, and C corporations. Most commonly, the term corporation is used to refer to a stock corporation or joint-stock company , which is a corporation where ownership is managed using stock.
Non-stock corporations that do not issue stock exist as well, the most common being nonprofit organizations. A few less common for-profit non-stock corporations also exist. In practice, people often use the word company to mean corporation. Corporations can be created in any country.
Employee Stock Options
In the United States, incorporation is handled by state law, and involves filing articles of incorporation and a variety of other required information with the Secretary of State. Note that the formation of companies that are not corporations, such as partnerships or LLCs, is not the same as incorporation.
It is the most prevalent kind of corporation. C corporations differ from S corporations and other business entities in several ways, including how income is taxed and who may own stock. C corporations have no limit on the number of shareholders allowed to own part of the company. They also allow other corporations, as well as partnerships, trusts, and other businesses, to own stock.
C corps are overwhelmingly popular for early-stage private companies looking to sell part of their business in exchange for investment from individuals and organizations like venture capital firms which are often partnerships , and for established public companies selling large numbers of stock to individuals and other companies on the public exchange. In practice, for a few reasons, these companies are usually formed in Delaware, so legalities of all this are defined in Delaware law.
Incorporating a company in Delaware has evolved into a national standard for high-growth companies, regardless of where they are physically located. Both equity and compensation are handled in significantly different ways in each of these kinds of businesses.
Stock option planning: Generating value
Loosely, one way to think about companies is that they are simply a set of contracts , negotiated over time between the people who own and operate the company, and which are enforced by the government, that aligns the interests of everyone involved in creating things customers are willing to pay for. Key to these contracts is a way to precisely track ownership of the company; issuing stock is how companies often choose to do this. Shares are portions of stock that allow a company to grant ownership to a variety of people or other companies in flexible ways. Each shareholder or stockholder , as these owners are called, holds a specific number of shares.
Founders, investors, employees, board members , contractors, advisors , and other companies, like law firms, can all be shareholders. Some companies now manage their ownership through online services called ownership management platforms , such as Carta. If the company you work for uses an ownership management platform, you will be able to view your stock certificates and stock values online. This number starts at an essentially arbitrary value such as 10 million when the company is created, and thereafter will increase as new shares are added issued and granted to people in exchange for money or services.
Later, we discuss several subtleties in how shares are counted. Although stock paperwork will always list numbers of shares, if share value is uncertain, percentage ownership is often a more meaningful number, particularly if you know or can estimate a likely valuation of the company. Even if the number of shares a person has is fixed, their percentage ownership will change over time as the outstanding shares change. Typically, this number is presented in percent or basis points hundredths of a percent. People can buy and sell the stock for cash on public stock exchanges.
Unlike a public company, where anyone is able to buy and sell stock, owners of a private company control who is able to buy and sell stock.