Equity vs. Salary: An Overview
Startups are known for being relatively cash-strapped, and they prefer to cut down on payments to employees considering their need to preserve cash and recycle whatever cash they generate into their business operations. They often offer equity compensation as a result.
The advantage of being paid a salary instead is that you know exactly what you're getting. It's a fixed sum that you can count on and plan your future around. Of course, you'll still be subject to the risk that your employer goes out of business or that your employment could be terminated, but salaries offer far more security than equity compensation overall.
Equity compensation often goes hand-in-hand with a below-market salary. They're not necessarily mutually exclusive.
The main risk associated with equity compensation is that it's not guaranteed that you'll gain from your equity’s appreciation. Too many variables can influence whether your equity stake will actually pay off.
First, the startup will have to succeed, and many flounder and go out of business. Consider how the dot-com bubble burst in 2000, leaving those who were offered stock options high and dry.
Equity compensation typically has a vesting schedule, which means that you'll only own your equity after a period of time. In the meantime, you'll be tied to the company as you watch for your equity pay to bear fruit. You could lose your stake if you're fired from the job.
There is a variety of ways of structuring equity payments, and each has its own advantages and disadvantages. You could be compensated in the form of incentive stock options (ISOs) or restricted stock units (RSUs).
You're not tied to the company in the same way when you earn a salary, and you keep whatever you earn when you earn it. But most large firms in any industry impose salary range structures, or pay grades, that cap the most you can earn, even after multiple years of service. Some top executive positions can be exempt from this rule. That said, someone who's just starting out can feel fairly confident that his pay will increase over time. Do the job and there's little risk involved.
According to the Bureau of Labor Statistics (BLS), "information systems managers" make the top 20 list of highest paid salary professions, but they come in at #16 on the list. The somewhat vague category of "chief executives" comes in at #12. Most of the top paying salaries go to those in the medical fields, and all these rankings are for those at the top of their games.
Equity vs. Salary Example
You have the potential for a major payout with options if your firm does succeed. You might even strike it rich if your firm comes out with a successful initial public offering. That’s how some of the earlier employees of companies such as Google (GOOG) and Facebook, Inc., became millionaires.
There's no such potential for any big payout in the future if you're earning a salary; you'll have to invest your income to generate any additional return.
You might find that you're in a hole after you pay taxes on equity income, even though you technically came out ahead. You might owe taxes even if your share price went down after you exercised your options and you own your shares. This introduces another element of risk. It’s important to exercise your equity options at the right time and to opportunistically cash in the shares you get so you can generate a real return rather than a paper return.
Each form of compensation has different tax consequences. It's important to know exactly how your employer is structuring your equity compensation because you could end up with a considerably bigger payout based on the form of compensation and the size of your stake in the company. A salary payment doesn’t involve that sort of complex structuring, except maybe to negotiate the timing of any bonus payout for tax-planning purposes.
(Further Reading: Sweat Equity)
- Equity is often promised along with a below-market salary. It's not always entirely an either/or situation.
- Equity compensation typically has a vesting schedule, which means that you'll only own your equity after a certain period of time. You're not tied to the company in the same way with salary payment.
- Tax implications of equity earnings can be far more complex than salary earnings.