What Is an Equity Grant and How Does It Work?

Equity grants are a key component of employee compensation, offering individuals a direct stake in a company’s future success. These grants help businesses attract skilled professionals, foster long-term commitment, and align employee performance with shareholder interests. By providing an ownership share, companies incentivize employees to contribute to growth and profitability. This compensation encourages employees to remain with the company, as the grant’s value often depends on continued service and company performance.

Defining Equity Grants

An equity grant is a form of non-cash compensation that provides an employee with an ownership interest in the company. Companies use these grants to motivate performance, retain talent, and attract new hires, especially in competitive markets or for early-stage businesses seeking to conserve cash flow. This creates a direct link between an employee’s efforts and the company’s financial outcomes. As the company’s value increases, so does the value of the granted equity, offering employees a pathway to wealth creation beyond their base salary.

Understanding equity grants involves several key terms. The “grant date” is when an equity award is formally approved and allocated. This date marks the start of the vesting period, when an employee gradually gains full ownership rights. Vesting schedules dictate the timeline and conditions for ownership.

Common methods include “cliff vesting,” where full ownership is earned all at once after a specific period, or “graded vesting,” where portions of the equity vest incrementally over time. Shares outstanding refer to the total number of a company’s shares held by all shareholders, including those from equity plans.

Common Types of Equity Grants

Among the various forms of equity compensation, stock options and Restricted Stock Units (RSUs) are the most frequently encountered. 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 exercise or strike price, within a set timeframe. This right becomes valuable if the company’s stock price rises above the exercise price, allowing the employee to buy shares at a discount.

Stock options are broadly categorized into Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). ISOs are granted only to employees and can offer potential tax advantages if specific holding period requirements are met. NSOs can be granted to employees, consultants, or outside directors and do not carry the same preferential tax treatment, usually resulting in taxable income at the time of exercise.

Restricted Stock Units (RSUs) represent a promise from the company to deliver a certain number of its shares to an employee once specific vesting conditions are satisfied, such as continued employment or achievement of performance targets. Unlike stock options, RSUs do not require the employee to purchase the shares. They generally retain some value as long as the company’s stock has value. RSUs become actual shares upon vesting, making the recipient a direct shareholder without an upfront cash outlay.

Other equity grant types exist. Employee Stock Purchase Plans (ESPPs) allow employees to purchase company stock, often at a discount of up to 15% from the market price, through payroll deductions. Performance Share Units (PSUs) are similar to RSUs but vest only upon the achievement of specific performance milestones, linking the award directly to measurable company or individual accomplishments.

The Equity Grant Lifecycle

An equity grant begins with its formal “granting,” the initial award to the employee. On the grant date, the company communicates the award’s terms and conditions, including the number of shares or options and the vesting schedule. This step establishes the employee’s potential future ownership, contingent upon meeting specified requirements.

After granting, “vesting” occurs, where the employee gradually earns full ownership rights to the equity over time or upon achieving certain conditions. For instance, in a common graded vesting schedule, a percentage of the shares might vest annually over several years, such as 25% each year over a four-year period. If an employee leaves the company before the equity is fully vested, any unvested portions are forfeited.

For stock options, once vested, the employee gains the ability to “exercise” them. Exercising an option means purchasing the company’s stock at the predetermined exercise price. This converts the right to buy shares into actual ownership. The employee must pay the exercise price, along with any associated taxes, to complete this transaction.

For RSUs, “settlement” occurs after vesting, converting vested units into actual shares. This conversion happens shortly after the vesting date, and unlike stock options, there is no purchase price for the employee to pay. The shares are delivered to the employee’s brokerage account, making them a direct shareholder.

After shares are obtained through option exercise or RSU settlement, the employee can pursue “sale/liquidity.” This involves selling shares in the open market to realize their financial value. The ability to sell shares depends on the company being publicly traded or having a mechanism for private share transactions.

Tax Considerations for Equity Grants

Understanding tax implications for equity grants is important, as income recognition occurs at different stages depending on the grant type. Equity compensation is subject to federal, and potentially state and local, taxes at various points. The income generated can be categorized as either ordinary income or capital gains, each subject to different tax rates.

For Non-Qualified Stock Options (NSOs), no tax is due at grant or during vesting. However, when an employee exercises NSOs, the difference between the fair market value of the shares on the exercise date and the exercise price is taxed as ordinary income. This amount is subject to federal income tax withholding, Social Security, and Medicare taxes. Any subsequent appreciation in share value after exercise is subject to capital gains tax when the shares are sold.

Incentive Stock Options (ISOs) offer a different tax treatment. No regular federal income tax is due at grant or exercise. However, the difference between the fair market value and the exercise price at exercise is considered an adjustment for Alternative Minimum Tax (AMT) purposes. If certain holding period requirements are met—selling the shares at least two years from the grant date and one year from the exercise date—any gain upon sale is taxed at the lower long-term capital gains rates. If these holding periods are not met, the sale is considered a “disqualifying disposition,” and a portion of the gain may be taxed as ordinary income.

RSUs are not taxed at the grant date. Instead, they are taxed as ordinary income upon vesting, when shares are settled and become unrestricted. The taxable amount is the fair market value of the shares on the vesting date. Employers are required to withhold taxes, though the actual tax liability depends on the employee’s overall income bracket.

When shares from any equity grant are sold, capital gains or losses may arise. If the shares are held for more than one year after vesting or exercise, any profit from the sale (the difference between the sale price and the tax basis established at vesting or exercise) is taxed as a long-term capital gain, typically at preferential rates. If held for one year or less, the profit is taxed as a short-term capital gain, which is subject to ordinary income tax rates. It is advisable to consult a tax professional for personalized guidance regarding specific equity grants and individual financial situations.