Good Equity vs. Bad Equity: Why Not All Equity-Based Compensation Plans Are Created Equal
Updated: Feb 15, 2022
The promise of equity
The most important objective of equity-based compensation is alignment. When workers are given a stake in the company’s success, they become more active and engaged. They devote more time and effort to their work and contribute more to the company knowing that its success is also theirs.
Once a worker personally identifies with a company and begins to adopt an owner’s mindset, true alignment takes place. Workers stop being outsiders to the company and become part-owners to a collective business enterprise. Like investors and business owners, they start to think about the company’s problems in the shower, on their way home, and in bed at night.
Equity done right promises a more engaged and aligned workforce. But equity can only deliver on this promise if its goals and conditions are effectively communicated and understood.
Other benefits of equity
Companies also offer equity as compensation to reduce worker salaries. This is especially helpful for companies that are looking for funding and for companies that want to attract top talent but can’t afford high salaries and benefits.
Equity compensation also acts as an effective deterrent from early resignation. Workers or employees who get equity become discouraged from leaving the company since the longer they stay, the more equity they will acquire, and if they leave too early they may not get any equity at all. Hence, it also tends to decrease turnover rates.
Good vs. bad equity
In order for equity to truly work, the people receiving it need to understand what equity is all about in the first place. Among the many types of compensation plans and packages, equity is perhaps one of the most difficult to understand and consequently, one of the most misunderstood.
It also doesn’t help that equity plans are often presented as complex legal agreements. Thus, if given a choice between cash and a stack of legal documents and papers that are hard to understand, a worker will almost always choose to be paid in cold hard cash.
Remember that good equity facilitates alignment. If your equity plan fails to do this then it definitely is not a good one. This is why confusing equity is bad equity, because confusion leads to misunderstanding. Your workers, for example, might interpret your equity offer as a way to cheat them out of a good chunk of their salary. If that’s the case, you will need to recalibrate your approach to equity, as there can potentially be negative effects on your team members.
Good equity also protects workers from negative tax consequences, and for having to pay out of pocket in order to own the equity they have worked for.
Bad equity leads to misalignment
If your workers view your equity plan as empty promises on a piece of paper, then you need to rethink it. An ill-thought-out equity plan can be a serious demotivator. Instead of aligning workers and employees, it can cause them to go astray and lose sight of company goals and objectives.
A common example of an equity plan that has a high chance of becoming bad equity is stock options. This is due to how a stock option plan usually works. It has several inherent disadvantages that may cause it to be a bad option for workers and employees.
Why stock options are a bad option:
Paying to receive compensation: Exercising a stock option may require the payment of thousands of dollars upfront. Having to pay in order to receive an award feels weird to workers. This creates cognitive dissonance.
Tax risk: Before they can be granted, stock options may require a “409A valuation” (based on Section 409A of the Internal Revenue Code) in order to determine its exercise or strike price based on the underlying share’s fair market value. Failure to do so may result in the imposition of tax penalties against the optionee.
Unexercised options have no value: Stock options are, well, options. If a worker can’t afford to exercise, the equity vaporizes. Despite being called an “option,” if a worker wants to gain its value, they have no other option but to exercise it.
Options expire: Stock options have an expiration date. The worker must exercise the option within a specific time period. Otherwise, it’s gone forever. So if a worker doesn’t have the cash on hand to purchase their options before they expire, they may lose it entirely.
Possibility of losing money: Money paid for the option’s strike price may be totally lost if the business or company goes bankrupt, which is always a possibility.
This is why stock options are falling out of favor amongst other reasons. These combined risk factors can cause confusion and misunderstanding among your workers. They also create a lot of legal overhead for the company. This is why experts in the subject are now advocating for the use of restricted stock units (RSUs).
Example of good equity: RSUs
RSUs represent a contractual promise to issue shares to a worker once certain prerequisites or conditions are met. Unlike stock options, workers who are granted RSUs do not have to pay anything to the company after they vest. This is because RSUs represent shares of the company, and once they vest, the worker receives the shares themselves. This is unlike a stock option which merely provides the worker the opportunity to buy the shares at a much lower price. Since RSUs represent company shares, they are always worth something once they vest, they also don’t expire once vested.
In addition, an employer granting RSUs is not required to do a 409A valuation. That saves the company time and money and reduces the risk of tax penalties.
To recap, the advantages of RSUs are:
No payment is needed to receive it: With RSUs, what you get is not the mere privilege to buy shares at a discount; you are granted the shares themselves. Hence, you don’t have to pay anything to the company just to receive them.
Less tax risk: Companies using RSUs don’t have to do a 409A valuation since RSUs don’t have a strike price that needs to first be determined. Thus, the risk of incurring tax penalties is mitigated.
It always has value: Since RSUs represent the shares themselves; they have intrinsic value once the actual shares are issued to the worker. There is no danger of not exercising RSUs because they don’t have a strike price. Vesting automatically entitles the worker to be paid in the corresponding shares.
No expiration date: Once vested RSUs are settled and paid out, the shares irrevocably belong and remain with the worker. Shares may decrease in value but they don’t have expiration dates.
You don’t lose money paying for the strike price: Mainly because you don’t have to pay for the strike price!
These advantageous features of RSUs tick all the checkboxes of a good equity plan. Upstock takes it a step further by making RSUs even better by taking advantage of legal innovations such as double-trigger vesting and the use of standardized legal agreements. Upstock also excels at plan communication, by showing team members the value of their RSUs growing over time. Achieving alignment does not need to be complicated or burdensome for both workers and companies. Our goal is to make this easy for companies and workers.