Many companies look to other forms of compensation to reward employees outside of standard cash paid wages and salaries. One common form is equity compensation. Equity compensation is the practice of granting non-cash pay that represents partial ownership in a company in exchange for services. The purpose of equity compensation is to allow the company’s employees to share in the profits through appreciation. Ideally, equity compensation should encourage the employees to work hard to make their employer successful, so they can share in its success. The three main types of equity compensation are stock options, restricted stock and performance shares.
Equity compensation in the form of stock options can give employees the right to purchase some of the company’s shares at an exercise price. In some situations, the right to purchase may vest with time, requiring employees to work for a period of time before gaining control of this option. Once the option vests, the employee gains the right to transfer or sell the option. The purpose behind this method is to encourage employees to stay with the company for the long term and to help avoid employee turnover.
Restricted stock is stock that is not fully transferable until certain conditions are met. Once the conditions are satisfied, the stock is no longer restricted and becomes transferable to the employee. An employee may have to forfeit restricted stock if they leave the company or fail to meet personal or corporate performance goals. Similar to stock options, the restrictions on the stock are intended to motivate employees to align their interests with the future of the company.
Finally, performance shares are a type of equity compensation that are only awarded if certain specified measures are met. If a company is attempting to reach certain metrics, such as return on equity, an earnings per share target, or the total return of the company’s stock, performance shares will be awarded if these metrics are met. The method behind performance shares is to motivate the management team to prioritize activities that will positively impact shareholder value.
Equity compensation is not limited to corporations. Other types of entities, such as limited liability companies, may have other types of equity compensation. For example, some entities issue separate classes of equity that allow the employee to share in the profits of an entity or participate in the proceeds from the sale of the company after other investors receive a specified rate of return.
Decisions related to equity compensation could have major financial consequences if not properly handled. These often don’t require an upfront cash payment so you may not be aware that there may be a financial statement impact. The ways that equity can be granted can complex due to the involvement of legal obscurities, confounding terminology, and many high-stakes decisions. Understanding the technicalities of equity compensation can assist in making better decisions and avoid making some costly mistakes.
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