What Is Equity Compensation and How Does It Work?
By Georgia Holmes
Equity compensation can give employees a stake in their employer's success. Discover how share options and employee share schemes work, their potential benefits and risks, and what to consider before accepting an award.
Equity compensation allows employees to receive a financial stake in the company they work for. Rather than relying solely on salary and bonuses, employees may receive shares or the opportunity to buy shares in the future.
It is commonly used by start-ups, growing businesses and established companies to attract talent, reward performance and encourage employees to contribute to long-term success.
For employees, equity compensation could become a valuable financial asset if the company grows in value. However, the benefits are not guaranteed, and the arrangements can involve restrictions, tax considerations and investment risks.
Read on to learn what equity compensation is, how it works, the main types available in the UK and what to consider before accepting an offer.
What does equity compensation mean?
Equity compensation is a form of employee reward linked to ownership in a company. Instead of receiving all your remuneration as cash, you may receive company shares or the right to acquire them later.
The precise arrangement depends on your employer's scheme. You might receive shares immediately, earn them over time or be given options that allow you to buy shares at a predetermined price.
For example, a technology company might offer an employee share options as part of their remuneration package. If the company grows and its share price increases, the employee could eventually buy shares for less than their market value, subject to the scheme's terms and applicable tax rules.
However, if the share price falls or the company fails, the options may be worth little or nothing.
Equity compensation is therefore a potential way to build wealth, rather than a guaranteed addition to your salary.
What are the main types of equity compensation?
Companies use several different arrangements. In the UK, these may include formal tax-advantaged employee share schemes and other share or option plans.
Share options
Share options give you the right to buy company shares at a specified price, often called the exercise price, once certain conditions are met.
You generally do not own the shares when the options are granted. You may need to wait until they vest and then decide whether to exercise them.
Suppose you receive options to buy 1,000 shares at £2 each. If the shares are worth £7 each when you exercise the options, they have a gross difference in value of £5 per share, or £5,000 in total, before considering costs and tax.
That does not necessarily mean you can immediately realise £5,000. You may need to pay £2,000 to exercise the options, and the shares may be difficult to sell if the company is privately owned.
Restricted stock and share awards
A company may award shares directly or promise to transfer shares once specified conditions have been met.
These conditions might include remaining with the employer for a set period or achieving particular performance targets.
Unlike options, which give you the right to buy shares, an outright share award may give you ownership once the shares are transferred. However, restrictions may apply to when…