What is 'Equity Compensation'

Equity compensation is non-cash pay that represents ownership in the firm. This type of compensation can take many forms, including options, restricted stock and performance shares. Equity compensation allows the employees of the firm to share in the profits via appreciation and can encourage retention, particularly if there are vesting requirements.

BREAKING DOWN 'Equity Compensation'

Equity compensation has been used by many public companies and some private companies, especially startup companies. Recently launched firms may lack the cash or want to invest cash flow into growth initiatives, making equity compensation an option to attract high quality employees. Traditionally, tech companies in both the start-up phase and more mature companies have used equity compensation to reward employees.

Example

For instance, LinkedIn's stock-based compensation in 2015 was $510.3 million, up from $319.3 million the prior year. In 2015, it represented over 17% of revenue. Over $460 million of the total was in the form of restricted stock units (RSUs).

Common Types of Equity Compensation

Companies that offer equity compensation can give employees stock options that offer the right to purchase shares of the companies' stocks at a predetermined price, also referred to as exercise price. This right may vest with time, allowing employees to gain control of this option after working for the company for a certain period of time. When the option vests, they gain the right to sell or transfer the option. This method encourages employees to stick with the company for a long term. However, the option typically has an expiration.

Employees who have this option are not considered stockholders and do not share the same rights as shareholders. There are different tax consequences to options that are vested versus those that are not, so employees must look into what tax rules apply to their specific situations.

There are different types of equity compensation, such as non-qualified stock options and incentive stock options (ISOs). ISOs are only available to employees and not non-employee directors or consultants. These options provide special tax advantages. With non-qualified stock options, employers do not have to report when they receive this option or when it becomes exercisable.

Restricted stock requires the completion of a vesting period. This may be done all at once after a certain period of time. Alternatively, vesting may be done equally over a set period of years or any other combination management finds suitable. RSUs are similar, but they represent the company's promise to pay shares based on a vesting schedule. This offers some advantages to the company, but employees do not gain any rights of stock ownership, such as voting, until the shares are earned and issued.

Performance shares are awarded only if certain specified measures are met. These could include metrics , such as an earnings per share (EPS) target, return on equity (ROE) or the total return of the company's stock in relation to an index. Typically, performance periods are over a multi-year time horizon.

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