What Is an Equity Award and How Does It Work?

An equity award represents a form of non-cash compensation that grants employees an ownership interest in the company. This type of compensation is typically provided in addition to a regular salary. Its fundamental purpose is to align the financial interests of employees with the company’s overall performance and success.

This alignment encourages employees to contribute to the company’s growth, as their personal financial gains can directly correlate with an increase in the company’s value. Equity awards serve as a tool for companies to attract, motivate, and retain skilled individuals, especially in competitive markets.

Common Types of Equity Awards

Equity awards come in several forms, each with distinct characteristics regarding how ownership is granted and when value is realized. These common types include:
Stock options
Restricted stock units (RSUs)
Restricted stock
Employee stock purchase plans (ESPPs)

Stock options provide an employee with the right, but not the obligation, to purchase a specified number of company shares at a predetermined price, known as the strike price, within a certain timeframe. The option’s value depends on the company’s stock price increasing above this strike price. There are two types of stock options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs).

Incentive Stock Options (ISOs) are granted to employees and can offer favorable tax treatment. For federal income tax purposes, no ordinary income tax is due at the time an ISO is exercised. However, the difference between the exercise price and the fair market value at exercise may be subject to the Alternative Minimum Tax (AMT). If certain holding period requirements are met, any gain upon sale is taxed at long-term capital gains rates.

Non-Qualified Stock Options (NSOs) can be granted to employees, directors, or other service providers. The “spread,” which is the difference between the fair market value of the shares at the time of exercise and the strike price, is taxed as ordinary income at the time of exercise. This income is also subject to employment taxes, such as Social Security and Medicare.

Restricted Stock Units (RSUs) represent a promise from the company to deliver actual shares of company stock, or a cash equivalent, to an employee at a future date once specific conditions are met. These conditions are time-based, such as remaining employed for a certain period, or can be tied to performance milestones. Until RSUs vest, the employee does not own the shares and does not have voting rights or receive dividends.

Once RSUs vest, the fair market value of the shares at that time is recognized as ordinary income for tax purposes. A portion of the shares may be automatically withheld by the employer to cover these income and employment tax obligations. After vesting, the employee receives the remaining shares and can choose to sell them or hold them.

Restricted Stock involves the direct grant of actual company shares to an employee, but these shares are subject to forfeiture until certain conditions are satisfied. Similar to RSUs, these conditions include a period of continued employment or the achievement of performance targets. Until the restrictions lapse, the employee may not be able to sell or transfer the shares.

Employee Stock Purchase Plans (ESPPs) allow eligible employees to purchase company stock at a discount to the market price. Employees contribute to these plans through regular payroll deductions over an “offering period.” At the end of the period, the accumulated funds are used to buy shares, often at a discount ranging from 5% to 15% of the stock’s market price.

Key Concepts in Equity Awards

Understanding the fundamental terms and processes associated with equity awards is important for managing their potential value. These concepts govern when and how an employee gains ownership of their awards:
Grant date
Vesting
Vesting schedules
Vesting date
Strike price
Expiration date
Forfeiture
Liquidity or the sale of shares

The grant date is the specific date on which a company approves and issues an equity award to an employee. This date establishes the award’s terms, including the number of shares or options granted and the original value. It marks the beginning of the award’s lifecycle.

Vesting refers to the process by which an employee earns full ownership rights over their equity award. Awards are not immediately fully owned but are earned over time or upon meeting specific conditions, such as continued employment or performance goals. Unvested awards cannot be sold and may be forfeited if the employee leaves the company or fails to meet the specified conditions.

Vesting schedules dictate the timeline for earning ownership. “Cliff vesting” means no portion of the award vests until a specific period, such as one year, has passed. If an employee leaves before the cliff, they forfeit the entire award. “Graded vesting” allows a percentage of the award to vest at regular intervals, such as monthly or annually, over a multi-year period. For example, a typical graded schedule might involve 25% vesting each year over four years after an initial one-year cliff.

The vesting date is the specific date or dates on which portions of an equity award become fully earned and no longer subject to forfeiture. Once an award vests, the employee gains full control over that portion. For stock options, exercising means purchasing shares at the predetermined strike price. This action converts the option into actual company stock.

The strike price, also known as the exercise price, is the fixed price per share at which an employee can buy company stock through a stock option. This price is usually set on the grant date. The expiration date defines the deadline by which stock options must be exercised; options not exercised by this date become worthless.

Forfeiture occurs when an employee loses the right to their unvested equity awards. This typically happens if the employee departs from the company before their awards have fully vested or if they fail to meet other specific conditions outlined in the award agreement. Once shares are vested, they are not subject to forfeiture.

Liquidity or the sale of shares refers to the ability of an employee to sell their vested shares once they have full ownership. For RSUs, shares become available to sell upon vesting. For stock options, shares can be sold after they have been exercised and acquired.

Benefits for Employees

Equity awards offer several advantages for employees, extending beyond traditional cash compensation. These benefits are designed to create a sense of ownership and shared success. The potential for wealth creation is a significant draw for employees receiving equity awards.

If the company’s value increases, the value of the employee’s equity awards can also grow substantially. This provides an opportunity for financial gains that may exceed what a traditional salary alone could offer. Employees can participate directly in the company’s financial success through this appreciation.

Equity awards align the interests of employees with the company’s long-term goals. When employees hold a stake in the company, they are more motivated to make decisions and take actions that contribute to its overall performance and profitability. This shared objective fosters a sense of collective responsibility and a focus on long-term value creation.

Equity awards play a role in employee retention and motivation. The vesting schedules associated with these awards encourage employees to remain with the company for a specified period to realize the full value of their grants. This structure helps companies retain talent and incentivizes employees to contribute consistently over time.