What Is an Equity Plan and How Does It Work?

An equity plan is a structured program designed by companies to offer employees a stake in the business, typically as company stock or the right to acquire it. This compensation goes beyond traditional salaries and bonuses, connecting an employee’s financial success with the company’s performance. Equity plans are a common tool in modern business for attracting, motivating, and retaining skilled talent in competitive markets. They allow employees to participate directly in the growth and profitability they help create.

Fundamental Elements of Equity Plans

Equity plans share core components dictating how employees receive and realize award value. The “grant” signifies the company’s commitment to provide equity or the right to it, specifying the number of shares or units and their terms. The underlying asset is company stock, or a derivative that tracks its value, representing partial ownership.

“Vesting” is how an employee gains full ownership or the right to exercise their equity award over time. Vesting schedules are crucial for retention, as unvested equity is forfeited if an employee leaves. Common vesting schedules include:
Time-based vesting: A portion vests after a specific period (e.g., 25% annually over four years).
Cliff vesting: No equity vests until a milestone (e.g., one year of employment) is met, after which a larger portion vests, followed by incremental vesting.
Performance-based vesting: Equity release ties to achieving specific individual or company goals.

Once equity awards vest, employees can “exercise” or “settle” them. For stock options, “exercise” means purchasing shares at a predetermined “strike price,” converting the right to buy into actual ownership. Restricted Stock Units (RSUs) “settle” by converting into actual shares or their cash equivalent once vesting conditions are met. The “valuation” of awards, at vesting or exercise, is based on the fair market value (FMV) of the company’s stock, which determines the taxable income.

Common Types of Equity Compensation

Equity compensation comes in various forms, each with distinct mechanics catering to different company goals and employee incentives.

Stock Options

Stock options provide employees the right, but not the obligation, to purchase a specified number of company shares at a fixed “exercise” or “strike price” for a set period. This price is the fair market value on the grant date. Employees benefit if the stock price rises above this exercise price, allowing them to buy low and potentially sell high. Stock options are subject to vesting schedules, meaning employees must remain with the company before they can exercise. Once vested, employees can exercise by paying the strike price, converting options into stock. Exercise methods include paying cash, or a “cashless” exercise where some shares are immediately sold to cover the purchase price and taxes, with remaining shares delivered.

Non-Qualified Stock Options (NSOs)

Non-Qualified Stock Options (NSOs) are a common stock option granted to employees, directors, and external consultants. When an employee exercises NSOs, the difference between the fair market value of shares on the exercise date and the lower exercise price is taxed as ordinary income. This income is subject to federal income tax, Social Security, and Medicare taxes. Any subsequent appreciation in the stock’s value after exercise is subject to capital gains tax when sold.

Incentive Stock Options (ISOs)

Incentive Stock Options (ISOs) are for employees only, offering more favorable tax treatment than NSOs if specific Internal Revenue Code requirements are met. There is no regular income tax due at grant or exercise. However, the difference between the exercise price and fair market value at exercise may be subject to the Alternative Minimum Tax (AMT). To qualify for long-term capital gains tax rates on the full profit, employees must hold the stock for at least two years from the grant date and one year from the exercise date. If these holding periods are not met, the sale is a “disqualifying disposition,” and a portion of the gain may be taxed as ordinary income.

Restricted Stock Units (RSUs)

Restricted Stock Units (RSUs) represent a promise from the employer to grant an employee shares of company stock or their cash equivalent at a future date, provided certain conditions are met. Unlike stock options, employees do not pay to acquire RSUs. RSUs are subject to vesting schedules, often time-based, which dictate when shares are officially transferred. Once vested, the fair market value of shares at that time is recognized as ordinary income and is subject to income tax and employment taxes. Companies often withhold a portion of vested shares to cover these tax obligations, and the employee receives the net shares. RSUs provide value even if the stock price declines, as long as it remains above zero, making them less risky than stock options.

Employee Stock Purchase Plans (ESPPs)

Employee Stock Purchase Plans (ESPPs) allow employees to purchase company stock, often at a discount, through regular payroll deductions. Employees contribute after-tax dollars to these plans over a defined “offering period” (three to 24 months). At the end of this period, accumulated funds purchase company shares. The purchase price is set at a discount (5% to 15%) from the stock’s market value, using the lower of the stock price at the beginning or end of the offering period. ESPPs offer a straightforward way for employees to acquire company stock and benefit from potential appreciation, often with tax advantages depending on how long shares are held before selling.

Phantom Stock and Stock Appreciation Rights (SARs)

Phantom stock and Stock Appreciation Rights (SARs) are equity compensation types that do not involve actual issuance of company shares. They are cash-settled awards whose value is tied to the increase in the company’s stock price over a specified period. Phantom stock grants employees “units” that mirror the value of actual shares, and upon vesting or a liquidity event, the employee receives a cash payment equal to the appreciation. SARs give employees the right to receive a cash payment equal to the difference between the stock’s current market price and a pre-determined base price. These awards are used by private companies or those wishing to provide equity-like incentives without diluting existing share ownership. The cash payment received from phantom stock or SARs is taxed as ordinary income upon settlement.

The Role of Equity Plans in Compensation

Equity plans serve as a strategic component within an organization’s overall compensation framework, extending beyond base salary and cash bonuses. For companies, these plans align employee interests directly with shareholders. By giving employees a financial stake in the company’s long-term success, equity plans encourage them to make decisions and take actions that contribute to growth and profitability. This alignment fosters a culture of ownership and shared responsibility, motivating employees to work towards collective goals.

Equity plans attract and retain top talent, particularly in competitive industries or for startups with limited cash flow. The prospect of sharing in the company’s future value can be a draw for potential employees and an incentive for current employees to remain long-term. Vesting schedules encourage employee loyalty and reduce turnover, as the full value of equity is realized only by continuous service. For employees, equity plans offer an opportunity to build wealth beyond fixed compensation. They can benefit from the appreciation in the company’s value, which can lead to substantial financial gains. This potential for wealth creation directly links an employee’s efforts to their personal financial growth, reinforcing their commitment to the company’s success.