If you are joining a startup firm or a relatively young firm, equity compensation could be a carrot that the firm dangles before you. Startups are known for being relatively cash-strapped and considering their need to preserve cash and recycle whatever cash they generate into their business operations, they prefer to cut down on payments to employees.
In return for giving you a below-market salary, they might give you a stake in the company in the form of equity compensation. That way, it’s a win-win, with the employees getting potentially adequate pay and the company conserving cash. For those who are weighing an equity payment possibility, keep in mind that there are some risks, as well as advantages, to getting an equity stake versus getting a salary payment.
Equity Does Not Equal Money in the Bank
The main risk associated with equity compensation is that it is not guaranteed that you will gain from your equity’s appreciation. There are too many variables that influence whether your equity stake will pay off. First and foremost, the startup will have to succeed. Many startups flounder and go out of business. Remember how the dot-com bubble burst in 2000 and a number of startups went out of business, leaving those who were offered stock options high and dry.
The advantage of being paid a salary is that you know exactly what you are getting. It is a fixed sum that you can count on and plan your future against. Of course, you will still be subject to the risk that your employer goes out of business.
How Mobility Is Affected
Equity compensation typically has a vesting schedule, which means that you will only own your equity after a period of time. In the meantime, you will be tied to the company as you watch for your equity pay to bear fruit. You may even lose your stake if you are fired from the job. With a salary payment, you are not tied to the company in that way and you keep whatever you earn.
Structuring Equity Compensation
There are a variety of ways of structuring equity payments and each has its own advantages and disadvantages. For instance, you could be compensated in the form of incentive stock options (ISOs) or restricted stock units (RSUs). Each form of compensation has different tax consequences. Thus, it is important to know exactly how your employer is structuring your equity compensation as you could end up with a considerably bigger payout based on the form of equity compensation offered and how much your stake in the company is. Obviously, a salary payment doesn’t involve that sort of complex structuring.
You may find that even though you exercised the equity options and came out ahead, you are in a hole after you pay taxes. Once you exercise your options and own your shares, you may find that you owe taxes even if your share price went down subsequently. This introduces another element of risk. That’s why a lot of people who were counting their paper riches eventually found themselves in the red as the dot-com bubble burst. Thus, it’s important to exercise your equity options at the right time and also to opportunistically cash in the shares you get so that you can generate a real return, rather than a paper return.
Bigger Payout Potential
On the positive side, with options, you have the potential for a major payout if your firm does succeed. You may even strike it rich if your firm comes out with a successful initial public offering. That’s how some earlier employees of companies such as Google (GOOG) and Facebook, Inc. (FB) became millionaires.
If you are being paid a salary, there is no such potential for any big payout in the future. You will have to invest your income to generate any additional return.
The Bottom Line
Equity payments allow startups to offer an incentive for employees even if they can’t match the salary payments of older companies. Even more established companies offer equity payments in a bid to stay competitive. While an equity stake offers the lure of a higher payout than a salary, it is also subject to much more risk.