This article is written by Devin Partida from ReHack Magazine.
Historically, only startup employees and senior executives regularly receive equity-only compensation. However, as more organizations are turning to it to attract top talent, create shareholder value, and drive success, you’re more likely to encounter it now as it becomes popular in more industries.
As a working professional, understanding what it is and when it’s beneficial can help you ensure your compensation package is fair. The more time you spend evaluating your options now, the faster you can respond to a potential employer when they extend a job offer.
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What is equity-only compensation?
Equity-only compensation is a noncash payment where you receive shares of company stock instead of a check or direct deposit. Instead of supplementing your earnings, it effectively replaces your salary. You get an ownership stake in the company, meaning you own a portion.
It’s similar to workplaces that offer salespeople 100% commission. However, since it provides no immediate, tangible wages, you can’t pay your living expenses with it. For this reason, it’s typically only offered to people working at startups or running the business — those who are there because they believe in the mission or have other income streams.
This method is particularly useful when organizations can’t match their competitors’ high salary offers. However, economic uncertainty and market volatility can impact its value, complicating matters.
Stock options
Many types of equity compensation options exist. Non-qualified stock options (NSOs) and incentive stock options (ISOs) are among the most common. Both let you acquire company shares at a set price. The former doesn’t qualify for favorable tax treatment, while the latter does.
You are eligible for NSOs as an employee, director, consultant, or advisor. On the other hand, ISOs are only available to employees.
ESPPs
Employee stock purchase plans (ESPPs) are employer-run programs that let you buy company stock at a set schedule. You get a discount, paying less than the fair market value. If you already plan on buying stocks in a specific company, it’s an excellent option.
Performance shares are handed out based on whether your workplace hits predetermined performance targets. For example, your goal could be to increase revenue by 12% in one quarter. Unlike promises of raises or bonuses, they’re guaranteed if you follow through.
RSUs and phantom stocks
Restricted stock units are substitutes for actual stock grants. You don’t receive stock. Instead, restricted stock units correspond in number and value to a specified number of shares. They’re like a promise to transfer shares at a later time once you meet a particular time or performance vesting requirements.
Phantom stock is similar. You get the benefits of stock ownership without receiving real company stock. A contractual agreement acts as a promise to pay a bonus — you receive cash equivalent to the appreciation value or full value at the time of payout. You don’t have to pay taxes since you don’t technically purchase shares.
According to the IRS, you generally don’t have to pay federal income tax when you receive or exercise a statutory stock option, such as ISOs and ESPPs. However, you might be subject to an alternative tax at the time of purchase. Generally, you treat this amount as a capital gain or loss, depending on whether you make or lose money.
Which sectors offer equity compensation?
Employers in the tech sector are more likely to offer equity-based compensation. However, numerous industries offer it to startup employees and senior executives.
This compensation model is increasingly popular in high-growth sectors where investors pour billions of dollars into promising businesses. Modern technology and subscription models have made it easier for companies to become disruptors and achieve consistent growth, enabling more industries to offer stock options instead of cash.
Key terms and concepts
To better understand equity-only compensation, you need to know a few key terms or jargon.
- Exercising: You’ll likely come across the term “exercising” often. Exercising a stock option means you are acquiring shares of a company's stock at the grant price.
- Vesting: Vesting is the process of earning stock options over time. Typically, it happens after you meet specific conditions, like reaching a certain length of employment or meeting performance targets. The vesting schedule is the timeline that dictates when you gain ownership of equity.
- Grant price: The grant price is the fixed price you pay per share to exercise your stock options. You can determine the value of company stocks by comparing its current market price to what it’s truly worth. This way, you can decide whether it’s overvalued, undervalued, or fairly priced.
- Price per share: This may impact your earnings. To sell stock, someone must be willing to purchase it at the market price.
- Liquidity: This measures how easily you can turn an asset into cash without considerably affecting its value. Stocks are liquid, so converting them into tangible wages is usually easy. If your company’s owner transfers ownership, the new owner may buy you out, giving you cash in exchange for your shares. This is more common with startups than with mature organizations.
The pros and cons of equity compensation
Equity compensation can be beneficial. You gain part ownership of the company, so you succeed when it does. Since noncash payments are often tied to performance, they can afford to offer more than standard hourly rates without impacting their cash flow — a win-win for them and you. The potential financial gains are compelling.
Say a startup offers you 5% of the company stock, 0.5% every six months. Its current monthly recurring revenue is $20,000, but it expects to reach $200,000 in five years after being acquired by a major enterprise. It claims the deal would increase the firm’s value to $20 million, so you’d get around $1 million when they exit.
In this scenario, you earn the equivalent of nearly $100 an hour if you work full-time. However, imagine the acquisition falls through, causing a short-term drop in stock price. If you went to sell, you’d get considerably less. Equity-based compensation is a gamble.
Other cons of equity-only compensation include difficulty converting assets to cash and dilution of ownership. Risk factors include market volatility, time stipulations, and mergers and acquisitions. Even if you have lots of equity, you can be far from having cash in hand.
Evaluating equity-only offers
Even though ISOs and ESPPs typically involve paying for shares at the grant price, you don’t pay for equity since you receive it in exchange for labor. Moreover, the figure should be based on data, not wishful thinking. If your potential employer forecasts growth, request the data that supports their claims.
People tend to overestimate the value of stock options when assessing job offers, wrongly assuming a higher number of shares translates to better compensation. A Harvard Business Review survey found that 44% of American workers can’t correctly answer one question about equity compensation. Just 5% of survey respondents got every answer right.
While having more shares means you own a larger portion of the business, your actual compensation depends on your earnings per share, which is determined by the company’s valuation. Depending on the type of equity compensation you have, everything from your vesting schedule to your professional performance can affect you.
You can use The BDO 600 as a benchmark. In 2023, CEOs received 69% of their compensation in equity, with the remaining 31% in cash. Chief financial officers had a similar salary breakdown, with 62% of their compensation coming from equity and 38% coming from cash.
factorsHow to negotiate for better payment terms
When you accept equity-only compensation, you’re taking a risk and helping the company grow. You should strongly consider negotiating for a higher percentage, especially if you apply to a startup. Consider a startup that successfully exits with $20 million. At 2% equity, you’d earn $400,000. Just one percentage point higher would net you an extra $200,000.
Don’t be afraid to be firm in negotiations. With millions of job vacancies in the United States, finding multiple employers offering equity-only compensation shouldn’t be too difficult. Review the firm’s financial potential and research similar businesses to make a solid case for better terms.
During negotiation, watch out for red flags like a lack of transparency, private company stocks — which you can only sell with approval from the issuing firm — high tax burdens, or excessive debt. To prevent changes in your equity structure, get everything in writing.
Additional factors you should consider
One of the most significant considerations is the actual work. Even if you earn more in equity than the average hourly employee in your field, you may technically lose money if you regularly work overtime since you don’t get time and a half. Like salaried workers, you may be required to be in the office for set hours.
Your employer can only legally mandate a schedule for you if you are an employee. As a contractor, you set your own hours. However, some equity compensation options are only available to employees.
It’s important to note that employees are typically guaranteed minimum wage. However, according to Section 13a of the Fair Labor Standards Act, executive, administrative, professional, outside sales, and computer-related employees are exempt from minimum wage and overtime pay requirements.
You can receive equity-only pay if you qualify. If not, you can only receive it to supplement your salary, not replace it. Your role determines eligibility, not your job title.
While learning all the ins and outs on your own is helpful, you don’t need to be an expert in the stock market to understand the pay structure. Ideally, your job should provide an ongoing education program or informational materials to help you figure out how to make informed decisions.
Make an informed decision about equity-only
Equity-only compensation is risky but can be rewarding. Now that you understand the basics, you can decide whether it’s right for you. Don’t rush into the decision, though — your choice can significantly impact your career path. Take your time, ensuring you make an informed decision that will work for both your career and financial goals in the short-term and long-term.