Equity compensation is (as its name suggests) any type of employee compensation comprised of equity in a company ("Company") in lieu of cash payment, including (1) restricted stock bonus/purchase plans; (2) incentive stock options; (3) non-qualified stock options; and (4) stock purchase plans.
Advantages of Equity Compensation
From the Company perspective, equity compensation (1) ties the employee's financial reward to the success of the business, aligning the employee's self-interest with the Company founder's self-interest; (2) does not generally involve Company cash and is therefore an attractive compensation technique for start-ups (or any company); (3) generates "leveraged" tax deductions, namely deductions in excess of the Company cash expended; (4) allows discrimination (in favor of executives); and (5) allows the Company to better attract and retain key employees.
From the employee perspective, equity compensation (1) provides an opportunity for a financial "home run;" (2) has no downside risk; and (3) provides tax benefits.
Disadvantages of Equity Compensation
From the Company perspective: (1) founders may feel they are giving up a piece of "their company;" (2) the rules are complex, and the tax (mostly to the employee) and accounting consequences (to the Company) of failing to follow those rules can be severe; (3) valuation of privately held companies is not a science - so there is little certainty the IRS will respect the value given to the equity compensation; and (4) given the lack of risk to the employee, there is a disparity between the risk and reward of the employees versus the founders.
Under the general rule of compensation (IRC §83), an employee has income equal to the fair market value of property received from the Company (less any amount paid) where (s)he receives it free of any substantial risk of forfeiture. The Company gets a deduction when the employee recognizes ordinary income. However, the employee can make a "§83(b) election" on "day one" and recognize income equal to the bargain element (if any) of property received even though that property is subject to a substantial risk of forfeiture. The benefit to the employee is that when the property does vest, employee has no further income so the appreciation is not then subject to tax. The risk to the employee is that if property is forfeited, the employee recognized income on day one and gets no deduction at time of forfeiture.
Restricted Stock Bonus/Purchase Plans
In a restricted stock bonus/purchase plan, the Company either gives or sells stock to the employee on the condition that the stock be returned to the Company for the amount, if any, paid by the employee if the employee's employment terminates before a stated date. After that date, the stock can be sold for its fair market value.
The advantages of restricted stock bonus/purchase plans are (1) the employee can make the §83(b) election; (2) the employee is generally entitled to capital gain treatment on sale of vested stock; and (3) the Company gets a wage deduction without paying cash wages. The disadvantage of a restricted stock bonus/purchase plan is that the employee has income but no cash with which to pay tax (of course, the Company can bonus cash to employee to cover the tax).
Incentive Stock Options (IRC §422)
Incentive stock options are options in Company stock meeting the requirements of IRC §422, concerning (1) a written plan; (2) term; (3) price; (4) employment at time of grant; (5) employment at time of exercise; (6) limit on option value; (7) restrictions on transfer; and (8) holding period.
The advantage of incentive stock options is the favorable tax treatment for employees (generally employees' favorite variety of equity compensation). The disadvantages are the statutory requirements (quite constrictive) and the lack of any deduction for the Company.
Non-Qualified Stock Options
A non-qualified stock option ("NQSO") is simply a stock option that fails to meet the requirements of an ISO.
The advantages of non-qualified stock options are that (1) they are more flexible than ISOs; (2) they can be granted to non-employees (e.g., directors and consultants); (3) there is no limit on the term of the options; (4) NQSO values can be more than $100,000/year; and (5) the Company gets a wage deduction upon exercise by employee. The disadvantages of NQSOs are that (1) the employee is taxed (at ordinary income rates) on inherent gain upon exercise of the option; and (2) they must now have a FMV (at grant) exercise price, like an ISO (or suffer serious tax consequences; IRC §409A).
Stock Purchase Plans (IRC §423)
Under stock purchase plans (IRC §423), employees are offered the right to purchase stock, usually through payroll deductions, at an exercise price that is no less than 85% of the value of the stock at the time the option is granted.
The advantages of stock purchase plans are that (1) employees may get a 15% discount tax-free; (2) they allow rank and file employees to feel they have a stake in the Company; and (3) they are popular with start-up companies who have just gone public (high expectations, generates cash to Company). The disadvantages of stock purchase plans are that (1) virtually all employees must be covered; (2) stock purchases are limited to $25,000 worth of stock (based on fair market value at time of grant); and (3) 5% or more shareholders cannot participate in the plan.
Though not technically equity compensation, phantom stock achieves some of the same goals. A phantom stock plan is basically a contractual promise by the Company to treat the employee as owning Company stock, but with no actual sale of stock and no actual grant of an option to purchase stock. The value of the Company's stock is used to measure the employee's compensation, but the employee is paid in cash, not stock. The employee is awarded a phantom "unit," which is a mere book entry entitling the employee to receive, either on exercise or at a stipulated time in the future, either the appreciation in value of the unit since the date of grant or the entire unit value.
The advantage of a phantom stock plan is that the employee does not become a shareholder and has no right to ever become a shareholder. The disadvantage of a phantom stock plan is that the Company must pay cash to the employee based on the Company's value, even if the Company is not then being sold to a third party for cash.