Equity Grant Guide: Types, Taxes, Risks & Negotiation

Equity grants are a powerful tool in compensation packages, offering employees a stake in the company’s success. As per Chris Dohrman of J.P. Morgan:

“Equity compensation allows employers to offer their employees more – which is great for the employees – while controlling the overall impact on the bottom line, cost efficiently, and usually with tax advantages.”

Hence, this guide will help you make informed decisions about your equity grant options and maximize their potential benefits.

Understanding Equity Grants in Compensation Packages

Equity grants are a form of compensation that gives employees the right to own a portion of the company’s stock. This type of incentive serves multiple purposes: 

• It encourages employees to remain with the company. 
• It aligns their interests with shareholders.
• It motivates them to actively contribute to the company’s success.

For employees, equity grants offer the potential for significant financial gain if the company performs well. This opportunity ties personal rewards to the company’s achievements, fostering a stronger connection to its growth and stability. For employers, equity grants serve as a cost-effective way to attract and retain top talent while aligning compensation with company performance.

Types of Equity Grants

Equity grants come in various forms, each designed to meet specific objectives and employee needs. Understanding these types is essential for evaluating compensation packages:

Employee Stock Options (ESOs)

ESOs provide employees the right to purchase company stock at a predetermined price (exercise price), after a vesting period. They include: 

• Incentive Stock Options (ISOs): These offer potential tax advantages if certain holding period requirements are met. Typically, no immediate tax consequences at exercise, but there are potential AMT considerations. Profits are taxed as long-term capital gains if held for at least one year after exercise and two years from the grant date. Otherwise, profits are taxed as ordinary income.
• Non-Qualified Stock Options (NQSOs): These are taxed differently from ISOs, typically as ordinary income upon exercise reported on the W-2 form. Profits are taxed as short-term capital gains if sold within a year of exercise and long-term capital gains if held longer.

For both ISO and NQSO holders, exercising options can require significant upfront capital. However, option exercise without cash allows employees to acquire shares without using personal funds. They can sell a portion of the shares at exercise to cover the cost. This can be a helpful solution for employees seeking to realize equity value without liquidity issues.

Restricted Stock Units (RSUs)

RSUs grant employees a set number of shares of company stock that vest over time. Unlike stock options, RSUs are typically granted for free, meaning no purchase is required. 

However, they are taxed when the units vest and are sold, which is an important consideration for employees planning their financial future. The value at vesting is included in taxable income, minus any amount paid. Profits from selling the shares are recognized and taxed as capital gains or losses, depending on the holding period.

Stock Appreciation Rights (SARs) & Phantom Stock

SARs and Phantom Stock are unique forms of equity grants that do not involve actual stock. Instead, they provide compensation tied to the company’s stock performance, avoiding shareholder dilution. 

Performance Shares & Performance Units

These shares and units are ways in which employers award equity to employees. As per Charles Schwab, they are awarded based on achieving a performance target set by your company within a specific period.

These equity grants can be tied to specific goals or milestones, making them an effective tool for aligning employee performance with company objectives. 

Employee Stock Purchase Plans (ESPPs)

ESPPs allow employees to purchase company stock at a discounted rate, often with vesting periods and restrictions on selling the stock. 

According to Equilar’s 2024 Report, 72% of companies report that having an equity compensation plan gives them a competitive edge during the hiring process. That is because these plans can be an attractive option for employees looking to invest in their company’s future while benefiting from a discount on the stock price.

Factors Influencing the Size of Equity Grants

The size of equity grants can vary widely based on several critical factors:

• Company Performance: Companies performing well may offer larger grants to reward employees and maintain success.
• Employee Role: Senior roles or key contributors often receive larger grants due to their impact on company outcomes.
• Market Conditions: Competitive landscapes and industry standards influence equity offerings.
• Vesting Period: Longer vesting periods may involve larger grants to maintain employee motivation and commitment.

Understanding Tax Implications of Equity Grant Package

When stepping into elite careers like growth equity, venture capital, or private equity, negotiating your equity grant package is about more than securing a job. It’s about shaping your financial future and aligning your interests with the company’s success. 

A key aspect of this negotiation is understanding the tax implications of your equity grants, as they can significantly influence the value of your compensation. Here are key steps you can do:

Step 1: Identify Your Levers

Start by identifying the key components of your compensation package, including base pay, variable pay, title, benefits, and equity. Knowing which of these levers you can push will help you maximize your overall compensation. For instance, if the company is cash-strapped but has high growth potential, you might focus on negotiating a larger equity stake.

Step 2: Research Tax Consequences

Different types of equity grants, such as ESOs, RSUs, and ISOs, have varying tax treatments. Understanding how and when these taxes apply is crucial:

• Tax Basis: This is usually calculated as the fair market value (FMV) of the shares at the time of vesting, minus any amount you paid for the grant.
• Ordinary Income Tax: Taxes apply to the difference between the grant price and the FMV at vesting or distribution. This can significantly impact your take-home pay.
• Capital Gains Tax: Holding shares for more than a year may qualify gains as long-term, taxed at a lower rate than ordinary income. If sold within a year, short-term capital gains taxes apply.
• Alternative Minimum Tax (AMT): ISOs may trigger AMT upon exercise. However, if a company allows early exercising of ISOs, employees can potentially mitigate AMT implications by exercising immediately upon grant and filing an 83(b) election within 30 days.

Step 3: Get the Numbers

Ask for detailed information about your equity grant, such as the number of options, strike price, fully diluted percentage of equity, cash value of the grant, post-termination exercise period, and vesting schedule. These details will help you assess the true value of your offer and its tax implications.

Step 4: Understand the Vesting Structure

Vesting schedules impact how long you need to stay with the company to fully benefit from your equity. Be mindful of cliffs (periods before any equity vests) and how they align with your career plans. 

For example, a typical linear four-year vesting schedule includes a one-year cliff, after which 1/48th of the equity vests monthly for the remaining three years. Adjust your expectations accordingly and plan your tenure to maximize equity realization.

Step 5: Forecast Impact

Forecast the potential growth of your equity by considering the company’s prospects and how additional capital raises might affect your ownership stake. Evaluate whether the company is over or undervalued to determine if the offer is fair.

Equity Grant Documentation and Paperwork

Navigating the documentation and paperwork associated with equity grants can be daunting, but it’s a critical step in securing your financial future. Here’s how the process usually goes:

Step 1: Create an Equity Grant Template

Using a template can streamline the process of creating and managing equity grants. This ensures consistency and accuracy in entering vesting information and grant details.

Step 2: Review Equity Grant Details

Double-check all the information in your equity grant. Confirm that the details are correct before finalizing the grant. This step is crucial to avoid any discrepancies that could affect your compensation.

Step 3: Consult the Equity Team

Don’t hesitate to reach out to the equity team for guidance. They can provide valuable insights and ensure that your equity grants comply with relevant laws and regulations.

Step 4: Attach Additional Documentation

Include any additional documentation that might be relevant to your equity grant. This could be anything from performance metrics to legal agreements. Having all the necessary information in one place will make it easier to manage your equity.

Risks and Strategies for Managing Equity Grants

Understanding the risks of equity grants and developing strategies to manage them is essential to maximize the value of your equity and align it with your financial goals.

Risks of Equity Grants

While equity grants can be a lucrative part of your compensation package, they come with their own set of risks: 

• Dilution of Ownership: As companies raise additional capital, your ownership stake may be diluted. This reduces your influence over company decisions and your share of potential profits.
• Dividend Payments: Equity financing often requires companies to make dividend payments, which can strain the company’s financial resources. Evaluating the company’s financial health and dividend policy is critical.
• Lengthy and Complex Process: Negotiating and finalizing equity grants often involves drafting detailed legal agreements, which can be time-consuming and costly.
• Loss of Privacy: Accepting equity financing often means sharing detailed financial and operational information with investors, which can compromise confidentiality.

Strategies to Mitigate Equity Grant Risks

Implementing targeted strategies can help you navigate the complexities of equity compensation and align your financial interests with your career objectives. Here are some key strategies to consider:

Refresh Grants

If offered, refresh grants provide additional equity but come with a new vesting schedule and cliff period. Treat these as opportunities to negotiate and plan for long-term retention incentives.

Accelerated and Backweighted Vesting

Explore alternative vesting structures like accelerated vesting (e.g., 40%/30%/30% over four years) for quicker returns or backweighted vesting (e.g., 10%/10%/40%/40%) to ensure long-term retention. Choose the structure that best aligns with your financial and career plans.

Monitor Dilution Risks

Regularly assess the company’s equity structure and how new funding rounds might impact your ownership stake. Staying informed will help you gauge the true value of your equity.

Seek Professional Advice

Consult with financial advisors or legal professionals to fully understand the implications of your equity grants, including tax consequences, dividend policies, and vesting terms.

Factors Influencing Equity Grant Structures

Equity grant structures and values are shaped by a combination of industry norms and a company’s stage of development. Understanding these influences can help employees and employers make informed decisions about compensation packages.

Industry Influences

Industry norms and company philosophies significantly influence how equity grant structures are designed. These norms and philosophies can include the following:

Industry Benchmarks

High-growth startups often offer larger equity stakes to attract top talent, while more established industries may provide smaller equity grants due to lower growth prospects. Comparing offers to industry benchmarks is essential for assessing competitiveness.

Company Culture and Philosophy

Companies with a culture of ownership may offer more generous equity packages to foster employee loyalty and engagement. This practice is especially common in tech and innovation-driven industries.

Equity Types

Different industries favor specific types of equity grants. Startups often provide stock options, while larger companies may prefer RSUs. Understanding the potential value and vesting schedules of these equity types is critical.

Startup Potential

A startup’s growth trajectory, market position, and value proposition can significantly impact the equity offered. Evaluating these factors helps determine whether the equity grant represents a meaningful stake in the company’s success.

Negotiation Strategies

Demonstrating your unique value to the company and tailoring your negotiation strategy to industry norms can help secure a fair and competitive equity package.

Company Stages

The stage of a company’s development influences the structure and value of equity grants:

Startup Phase

In the early stages, founders typically hold a significant equity stake, with equity options primarily allocated to founders and key early hires. These early-stage equity grants often come in the form of stock options, with vesting tied to milestones or time-based criteria. 

This setup offers potential upside as the company grows, making it an attractive proposition for those willing to take on the risk. The vesting period usually spans 4 to 5 years, and equity grants are awarded as a percentage of company ownership, which can be a golden parachute for early employees if the company succeeds.

Growth and Series B/C Phases

As companies mature, equity grants become more structured. Companies might adjust their equity strategies by incorporating the following:

• Time-based RSUs: Equity grants are typically made annually, with amounts determined by comparing compensation for peer levels at similar companies. At least 50% of each annual grant is time-based, vesting over 4 or 5 years. 
• Share-based awards: A portion of the equity pool is reserved for new hires and potential acquisitions, while a smaller reserve is set aside for promotions and junior hires. The remaining equity is allocated to the management team, with the CEO often receiving a significant portion.  

Additionally, factors such as the size of the employee equity pool, compensation costs, and administrative expenses also play a crucial role in determining the structure and amount of equity grants. 

International Considerations for Equity Grants

When dealing with international equity grants, companies must navigate a complex landscape of global equity plans, tax withholding, and local labor laws. Successful companies often use cross-functional teams to analyze relevant issues and make necessary decisions before the first grant or offer occurs. These teams typically includes members from the following departments:

• Legal
• Tax
• Accounting
• Treasury
• Human resources
• Equity plan administration

Enhanced tax withholding is a crucial factor to consider when dealing with international equity grants. Companies should enhance the tax withholding section of their documents to accommodate procedures required by local law. Methods may include the following:

• Withholding in shares 
• Cash from the employee’s compensation 
• Requiring the employee to provide a check to cover the tax withholding amount

These methods ensure compliance with local regulations and avoids potential legal issues.

Addressing local labor laws is another important aspect of international equity grants. Labor laws in many countries outside the US require modifications to grant agreements. 

Using a single award agreement with an appendix containing the data required by individual countries can be less cumbersome administratively than having separate agreements for each country. This approach streamlines the process and ensures compliance with local regulations.

Future Trends in Equity Grant Compensation

The landscape of equity grant compensation is constantly evolving, with new trends emerging in both public and private companies. 

In public companies, there is a growing trend towards offering accelerated new hire grants, which are front-loaded with a higher percentage of equity vesting in the early years. This trend is reflected in both new hire and refresh grants, as companies seek to attract top talent in a competitive market.

Private companies, on the other hand, have traditionally leaned towards linear grants. However, there is a growing interest in exploring alternative vesting schedules, including accelerated and backweighted structures. These alternative structures can provide more flexibility and align better with the company’s growth strategy and employee retention goals.

Incentive plan design is another area of focus for companies looking to align participants’ interests with company strategy, shareholder expectations, and the competitive market. Companies are evaluating existing incentive arrangements and developing new plans that incorporate the following:

• Long-term incentives
• Short-term incentives
• Goal setting
• Performance metrics
• Statistical modeling
• Accounting
• Tax considerations 

This comprehensive approach ensures that equity grant compensation remains competitive and aligned with the company’s overall objectives.

Real-Life Examples

Several companies have implemented notable equity grant programs to attract and retain talent. Here are some real-life examples:

• Salesforce: Salesforce has been a pioneer in addressing pay equity through equity grants. In 2021, the company added equity grants as part of their annual stock refresh program. This will cover stock awards to eligible employees.
• Verizon: Verizon implemented a program called “Stock Together,” which grants equity awards to all employees, including hourly workers.
• Apple: As per of its benefits, Apple grants every employee the opportunity to earn Apple stocks. These grants increase or decrease in target size based on the company’s total shareholder return (TSR).