Equity Incentive Plans Explained

According to a Morgan Stanley report, 84% of employees see stock ownership and equity incentives as valuable benefits that drive their commitment. 

When employees have a stake in the outcome, their dedication grows and they become more invested in the company’s long-term success.

What is an equity incentive plan?

An equity incentive plan grants employees ownership through stock options, Restricted Stock Units (RSUs), or other equity-based rewards. 

It aligns employees' interests with the company’s growth by linking rewards to performance, tenure, or milestones.

Equity incentive plans help startups and high-growth companies reward employees without relying solely on salaries.

How do equity incentive plans work?

An equity incentive plan sets aside a specific number of shares from the company’s total authorized shares to create an equity pool or option pool.

The size of the pool is based on industry benchmarks, growth projections, and hiring needs. Companies may adjust it over time as they scale.

ESOP pools in the U.S. often start at around 10% during the seed stage and expand to 15% by Series A, gradually increasing with each funding round. According to Index Ventures, by Series D, the pool can grow to 20% or even 25%.

Until granted, these shares remain unallocated but are included in the company’s cap table as part of the total outstanding shares. When employees receive equity, it is issued from this pool.

Who is eligible for an equity incentive plan?

Full-time employees are the primary recipients of equity incentives such as stock options (ESOPs) and Restricted Stock Units (RSUs)

Startups often offer equity to new hires when they cannot compete on salary but may later restrict it to key roles as they grow. Senior management and key employees typically receive larger grants.

External advisors and consultants are generally not eligible for ESOPs, as most regulatory frameworks restrict participation to employees. However, companies may offer alternative incentives such as phantom stock or Stock Appreciation Rights (SARs).

Types of equity incentive plans

Companies offer various equity incentive plans, each with its own advantages.

1. Stock options

Stock options give employees the right, but not the obligation, to purchase company shares at a pre-determined price (exercise price/strike price). 

These options vest over time according to a set schedule, allowing employees to exercise them gradually.

If the company’s stock price rises above the exercise price, employees can buy shares at a discount and potentially sell them for a profit.

2. Restricted Stock Units (RSUs)

Restricted Stock Units (RSUs) are company shares granted to employees that vest over time. Unlike stock options, RSUs do not require employees to buy shares. Once vested, shares are automatically transferred.

Since RSUs always hold value unless the stock price drops to zero, they are a lower-risk alternative to stock options.

3. Stock Appreciation Rights (SARs)

SARs allows employees to benefit from the company's stock price increase without actually owning shares. 

Instead of purchasing stock at a fixed price like stock options, employees receive the financial equivalent of the stock’s appreciation over a set period. 

When SARs vest, employees receive a cash payment or stock equal to the difference between the grant price and the market price at the time of exercise.

This makes SARs an attractive alternative for companies that want to offer equity-based incentives without diluting ownership.

4. Employee Stock Purchase Plans (ESPPs)

According to a 2023 Deloitte survey, companies with ESPPs tend to outperform those without them in key metrics like TSR, EBITDA, EPS, and revenue growth over the long term, making it an essential incentive strategy.

ESPPs allow employees to purchase company shares at a discounted price through payroll deductions. 

ESPPs operate on an offering period, during which employees contribute a portion of their salary to purchase shares at the end of the period.

Some ESPPs have a lookback feature, which allows employees to buy shares at the lower of the stock price at the beginning or end of the offering period.

What are the benefits of using equity incentive plans?

Equity incentive plans are now a vital part of modern compensation packages. Here’s why:

1. Boosts recruitment efforts

Beyond financial potential, equity gives a sense of ownership to employees.

In competitive industries, job seekers expect equity and sometimes negotiate for a larger share instead of a higher salary.

For startups, equity helps close pay gaps and makes entry-level roles more appealing.

2. Increases employee ownership

Equity incentive encourages long-term thinking, responsibility, and commitment. Employees become more invested in the company’s success, take greater initiative, and make decisions with the bigger picture in mind.

3. Reduces turnover

Vesting schedules encourage employees to stay with the company longer, as they must remain employed to fully receive their equity. This reduces turnover, saving businesses the costs of hiring and training new employees. It also helps maintain stability and retain experienced talent,

4. Reduces salary costs

Salaries are one of the biggest expenses for a company, taking up a large part of the budget. Equity incentive plans help businesses offer competitive pay while keeping salary costs under control.

Employees still get a regular pay cheque, but they may accept a lower salary in exchange for the potential financial benefits of owning company shares.

Tax implications of equity incentive plans for employers and employees

Equity compensation comes with specific tax responsibilities for both employers and employees. The tax treatment varies based on the type of equity granted and the local tax laws.

For employers:

Employers are responsible for withholding and reporting taxes when employees exercise stock options, SARs, or when RSUs vest.

• For stock options and SARs, taxable income is typically reported at the time of exercise while RSUs are taxable at vesting.
• If the ESPP has a lookback feature or discount, the discount portion may be taxable as compensation when shares are purchased.

For employees:

• Stock options: Employees are taxed at exercise on the difference between the exercise price and the current fair market value (FMV) of the stock. If they later sell the stock, they may also be taxed on any capital gains.
• RSUs: RSUs are taxed as ordinary income at the time they vest.
• SARs: Employees are taxed at exercise on the difference between the grant price and the stock's market price.
• ESPPs: Employees may be taxed when they purchase shares (if the plan offers a discount) or when they sell the shares.

FAQs

1. What are the main types of equity incentive plans?

The most common types of equity incentive plans include stock options, Restricted Stock Units (RSUs), Stock Appreciation Rights (SARs), and Employee Stock Purchase Plans (ESPPs). The choice of plan depends on the company’s goals, the employee’s role, and the stage of the company’s growth.

2. How do equity incentive plans benefit employers?

According to a Morgan Stanley report, more than 84% of employees consider equity compensation as strong incentives. Additionally, a 2023 Deloitte survey shows that companies offering Employee Stock Purchase Plans (ESPPs) outperform those without in key financial areas like Total Shareholder Return (TSR), EBITDA, EPS, and revenue growth.

3. How do employees benefit from equity incentive plans?

Equity compensation enables employees to accumulate long-term wealth as the company grows. If the company's stock price rises, employees have the potential to reap significant financial benefits.

4. What is the difference between an ESOP and an equity incentive plan?

An ESOP (Employee Stock Option Plan) is a specific type of equity incentive plan that grants employees the right to purchase company stock at a pre-determined price, subject to vesting conditions.

In contrast, an equity incentive plan is a broader category that includes various forms of equity-based compensation, such as ESOPs, RSUs, SARs, and ESPPs.