What Is an Equity Award and How Do They Work?

Equity awards represent a significant and increasingly common component of employee compensation within the modern workforce. These awards offer individuals a stake in the company they work for, moving beyond traditional salaries and bonuses. Their growing prevalence reflects a strategic shift in how businesses attract, incentivize, and retain talent, aligning employee interests with long-term business success and fostering a sense of shared ownership.

Defining Equity Awards

An equity award is a form of non-cash compensation that provides an employee with an ownership interest in the company. This type of compensation contrasts with traditional cash payments. Equity awards are designed to align employees’ financial interests with the company’s overall performance and growth. As the company’s value increases, so too can the value of the awards, encouraging employees to contribute to the company’s long-term success.

Common Types of Equity Awards

Equity compensation encompasses various forms, each with distinct characteristics and tax implications.

Restricted Stock Units (RSUs)

Restricted Stock Units (RSUs) are a promise from an employer to grant company shares to an employee at a future date, provided certain conditions are met. These awards are “restricted” because they are subject to vesting conditions, typically based on continued employment or achieving specific performance milestones. Upon vesting, the fair market value of the RSU shares is generally taxed as ordinary income, subject to federal, state, and payroll taxes.

Stock Options

Stock options grant an employee the right, but not the obligation, to purchase a specified number of company shares at a predetermined price, known as the exercise or strike price, within a set timeframe. There are two primary types: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). ISOs are exclusively granted to employees and can offer preferential tax treatment, where generally no ordinary income tax is due at exercise, though the Alternative Minimum Tax (AMT) may apply. NSOs can be granted to employees and non-employees alike. When NSOs are exercised, the difference between the fair market value of the stock and the exercise price (the “bargain element”) is immediately taxed as ordinary income.

Employee Stock Purchase Plans (ESPPs)

Employee Stock Purchase Plans (ESPPs) allow employees to purchase company stock, often at a discount, through payroll deductions. ESPPs can be either qualified under Internal Revenue Code Section 423 or non-qualified. With qualified ESPPs, employees are generally not taxed at the time of purchase, but rather when they sell the shares, with a portion of the gain potentially taxed as ordinary income and the rest as capital gains. Non-qualified ESPPs typically result in the discount being taxed as ordinary income at the time of purchase.

Phantom Stock Plans

Phantom stock plans provide employees with the financial benefits of stock ownership without actually transferring company shares. These plans track the value of the company’s actual stock, and participants receive cash payments tied to this value. Payouts from phantom stock are generally taxed as ordinary income when received, and the plans are typically subject to Section 409A.

Stock Appreciation Rights (SARs)

Stock Appreciation Rights (SARs) give an individual the right to receive a cash payment, or sometimes shares, equal to the appreciation in value of company shares. Unlike stock options, SARs do not require the employee to purchase shares. There are generally no tax consequences when SARs are granted; however, upon exercise, the value received is taxed as ordinary income.

How Equity Awards Function

The lifecycle of most equity awards follows a progression from grant to eventual ownership or payout. The “grant date” is when the company offers the equity award to the employee. At this initial stage, there are typically no immediate tax implications for the recipient.

Following the grant, equity awards are subject to a “vesting schedule,” which specifies the conditions that must be met for an employee to gain full ownership rights. Vesting can occur over a period of time or upon the achievement of specific performance goals or corporate milestones. If an employee leaves the company before their awards are fully vested, they typically forfeit any unvested portions. This vesting mechanism serves as a retention tool, encouraging long-term commitment to the company.

For stock options, once vested, the employee gains the “right to exercise” the option, meaning they can purchase the company’s shares at the predetermined exercise or strike price. The financial benefit from exercising an option arises if the current market value of the shares is higher than the exercise price. The tax implications of exercise vary significantly depending on the type of stock option. For other equity awards like RSUs, vesting directly leads to the employee receiving the shares, at which point tax is typically recognized.

Reasons Companies Grant Equity Awards

Companies strategically grant equity awards to achieve several objectives beyond traditional cash compensation. A primary motivation is to attract and retain top talent, particularly in competitive industries or for startups with limited cash flow, as offering a stake in the company makes compensation packages more appealing and competitive.

Equity awards also serve to align employee interests directly with shareholder value and the company’s long-term performance. By providing employees with an ownership interest, companies encourage them to think and act like owners, fostering a greater sense of responsibility and commitment. For early-stage companies, equity compensation can help conserve cash flow by reducing the need for high upfront salaries.