What Is Carrot Equity?

Carrot equity is financial incentive in the form of company shares granted to a manager (or key employees) of a firm who meets specified financial targets or operational goals. Carrot equity is dangled in front of managers to encourage them to work harder to attain sales objectives or any number of financial metrics, such as earnings per share (EPS), EBIT margins, free cash flows, leverage ratios, etc., depending on the type of firm. A manager could also receive carrot equity by achieving business milestones, such as completing the integration of a bolt-on acquisition, closing a divestiture of a non-core asset, or establishing factory operations in a new market.

Key Takeaways

  • Carrot equity refers to a non-cash incentive for managers at a company, generally a startup, to reach their goals or milestones at work.
  • Stock options and performance-oriented restricted shares are the two most common types of carrot equity.
  • Excessive carrot equity grants can cause unacceptable shareholder dilution.
  • Appropriate amounts of carrot equity is considered good corporate governance practice.

Understanding Carrot Equity

Carrot equity is generalized to mean a non-cash incentive for managers of a company. This type of equity is offered at companies large and small, but it may be more important as a compensation tool at smaller firms or startups because the cash necessary to pay leading employees could be in shorter supply. These managers are normally attracted to the financial upside potential that equity presents. The payoff of equity can be much greater in the future than a routine salary. When properly structured, a compensation plan that includes carrot equity can create powerful incentives for managers to work hard, make wise decisions, balance short-term imperatives with long-term strategy, and act as responsible corporate citizens.

Main Types of Carrot Equity

Stock options and performance-oriented restricted shares are two common types of carrot equity. Such awards to "named executive officers" (NEO) are tied to key financial targets or specific near-term business objectives. A firm's proxy filing (SEC Form DEF 14A) contains, or should contain, a description of the objectives that would lead to the granting of the equity to the NEOs. An investor studying a carrot equity plan should be mindful of whether it is too generous to the executives. Excessive equity grants for meeting low hurdles, for instance, is sub-optimal from a performance standpoint; moreover, it tends to cause unacceptable shareholder dilution. Appropriate amounts of carrot equity for reasonable financial or operational targets is part of good corporate governance practices.