An equity-based incentive plan involves companies compensating employees, partners, directors, contractors, or other parties by issuing them shares or units in an equity plan to attract, retain, and encourage employees to be committed to the company.
Essentially, employees get shares in their company through the equity incentive scheme. Accordingly, by giving out equity awards, the interests of the recipients are more closely aligned with those of the subject company and its owners.
Recently, equity-based incentive plans are becoming more popular, especially among startups that adopt it as a recruitment strategy because they may still need to make significant profits or have a consistent cash flow to pay employees.
Why Equity Incentive Plan?
- Equity incentive plans offer a new way to recruit the best talent: Because a small startup may not offer a large corporate salary, companies can attract the best talent to work in exchange for equity in the firm. Hence, the frequency of startups providing employees, including entry-level ones, with shares has contributed to the rise in the popularity of equity sharing. With adequately constructed equity offers, employees will be encouraged to stay dedicated and committed to the company’s growth which will also help companies stay competitive and guarantee they can continue hiring top employees.
- Because employee equity incentive plans are subject to vesting schedules, it helps to reduce the employee turnover rate. Generally, employees may be mandated to remain in the company for two to ten years to enjoy the full benefits of the equity plan incentive. This depends on the provisions of the vesting schedule in the agreement.
- Helps companies save cash: Offering stock, which employees typically can only cash in on much later, enables companies to preserve money in the interim. This is because employees get reduced salaries in exchange for some future shares, which is vital for companies with minimal resources and funding.
- An equity incentive plan will distinctly match the interests of your employees with that of the company. Employees who own stock in a firm or have options to buy stock will be encouraged to overperform to ensure the company succeeds. After all, doing so would increase the value of their shares.
Types of equity-based incentive Plans and how they work
- Employee stock option: This equity-based incentive plan is the most common, and it allows employees to purchase company stock at a predetermined price, called the exercise or strike price, which is usually the fair market value when the stock option is offered.
- Restricted stock award: Unlike the stock option, a Restricted Stock Award (RSA) does not give a purchase option but rather a grant of company stock. Reputed and established organizations typically give them to seasoned executives who have proven their loyalty to the company. Furthermore, the rights of regular stockholders, including dividends and voting rights, are instantly granted to RSA holders. However, RSAs are subject to a restriction period known as the vesting period, which may be predetermined for a specific period or determined by the company’s performance. If an employee quits their job before the vesting term has ended, the RSA could be lost.
- Stock Appreciation Right: Stock Appreciation Rights (SARs) are a unique employee equity plan that pays the cash equivalent of stock value. Instead of actual stock, recipients receive the cash equivalent of a particular number of shares. No exercise price is demanded of employees. However, the company still adds value to the employee’s overall compensation package while managing to avoid dilution. SARs are frequently given along with stock options so that employees can purchase the stocks and offset any taxes that may be owed. SARs are vested just like all other equity plans are.
- Phantom Share Plans: Phantom Share Plans are deferred compensation that gives employees one or more cash incentives, whose value is based on the market value of the company’s shares. Usually, the cash incentives are often given out on a predetermined date or whenever a “trigger event” takes place. The structure of a phantom share scheme varies from firm to firm, such as an increased valuation or an exit.
In conclusion, equity incentive plans are a great addition to a compensation package. These incentives help attract and retain talent while fostering the company’s long-term growth without having an immediate detrimental effect on cash flow. However, an effective employee equity compensation plan must aim to build a healthy bond between the employee and the firm. Hence, the employee must be adequately motivated to deliver their best effort.
Employees who participate in equity programs put in more overtime and dedication to work, increasing the company’s employee retention rate, which is essential to the company’s success.