In the tech world, like other industries, startups sometimes offer equity to employees instead of cash. Equity-based compensation is a great incentive to keep employees devoted to your company, but handing company equity over to employees comes with plenty of problems as well.
What Does It Mean to Give Employees Equity?
When you give employees stock or equity in your business, you’re giving them partial ownership of the company. Like owner’s equity, employees will own a percentage of the business’ total worth. This is also known as a stock grant or a stock option. Giving employees a share of the company’s equity, typically in the form of stock or options, has complex legal and tax implications.
How Do Businesses Use Equity Compensation?
Employee equity is also known as equity compensation. A business will offer a slice of their company to their employees to compensate for their work versus just being paid a salary. This non-cash compensation is typically provided as a means to offset the below-market pay they receive.
Equity compensation is generally offered to startup employees versus well-established businesses. A startup founder can find it is easier to provide staff with a partial salary and stocks instead of a larger salary and no equity, as they may not have the cash to cover the payroll of market-price wages.
Equity vs. Salary
Salary is paid to employees in the form of wages, whereby money is deposited into the person’s account for their hours worked at the business. Equity refers to the business’ worth, meaning employee stock and equity is the employee’s individual share of the company’s total worth.
Advantages of Entry-Level Employee Stock Options
If you’re running a startup, the top talent you seek may expect stock as a condition of working for you. Having partial ownership in the company is a great incentive and can boost loyalty. As the head of your company, you know you have to wait for a big payout, and when your employees have equity, they share that long-term attitude. Depending on how you schedule the vesting of equity, you can also keep employee turnover to a minimum.
Giving out equity also benefits your company. As a startup, your funds might be tight. Providing stock grants in early stage startups lets you reduce the money you need for salaries. That means you’re also less likely to hire someone looking to cash out at your expense, and it reduces the need to raise funds. Finally, you may be in need of some serious talent as you get started, and handing out equity gives you a chance to snag the right people.
On top of these benefits, employees who own a part of the company can work harder than those who don’t, as they feel like they have skin in the game. Therefore, equity stock options can boost loyalty and work ethic as this workforce has a driving interest in the company. If the business financially grows, so too does the employee’s net worth.
Disadvantages to Entry-Level Equity
That being said, equity-based compensation is complex, very complex. You need to talk to a securities attorney to make sure you’re complying with securities and anti-fraud laws and a tax attorney to handle the complicated tax implications. When an employee with equity leaves, the restructuring that’s involved gets complex all over again.
Selling your company is also more complicated if you’ve given away equity, as many purchasers may want to buy 100% of the company. What are you going to do if one of your equity-holding employees balks at the sale? By the same token, since your employees’ shares are virtually worthless until you sell the company or take it public, they may pressure you to sell when you don’t want to. What happens when the employee leaves?
You also give up a lot of privacy when you have shareholders. Are you prepared to open up your books to your equity-holding employees? You may also find that your employees aren’t up to the task of ownership and shy away from some tough decisions that come with the territory. Finally, when your company starts to turn a profit, you may discover you were too enthusiastic about what your employees could bring to your business and gave away too much of the company.
Weighing the pros and cons of offering equity stake to entry-level employees is crucial, especially if your company is a startup. Look past the current needs of your business to make a decision that’s right for its future.
How Equity Theory Can Help You Decide What to Do
Have you ever heard one of your coworkers or employees say, ‘I’m not paid enough to do that’? This is the manifestation of equity theory in real life. The equity theory of motivation asserts that individuals in a work setting will adjust their work ethic and output to align with what they think is fair compensation for their efforts. In simpler terms, employees match their work output to their wages.
For example, suppose Michael and Andrew possess the same job title and cover the same responsibilities. However, Michael is getting paid more than Andrew to do the same job. Once Andrew discovers the difference in wages, he decides to lower his work output to what he sees as a fair exchange for his compensation. He is directly producing the amount of work he feels is in line with his wages.
An individual’s output is linked to other people’s output around them, and what the workers feel is accurate compensation for their blood, sweat, and tears versus others. If a company provides stock grants to all of its workers, this can offset the disparity in work that equity theory sometimes creates.
What Percentage of the Company’s Equity Should be Given to Employees?
If you decide that your startup or business could benefit from offering equity compensation to its workforce, what percentage of the company should be handed over to them? Is 1% enough to offset a lower salary? 10%?
Companies will need to determine their cash equity ratio to understand how much cash they have on hand compared to the total net worth of the business. This cash equity ratio helps investors and business owners with equity valuation. The typical startup equity % tends to fall between 10 and 20% of the total shares of the company, also known as the employee equity pool, where all employees’ shares fall into.
Equity valuation measures the overall value of the company, comparing its current assets against its current liabilities. Equity valuation is also a necessary part of calculating a company’s equity plan, alongside the employees’ market salary rate and their current salary at the company.
Cash equity ratio formula
The cash to equity ratio is expressed as a percentage and is determined using this formula:
Cash Equity Ratio = Total Shareholders Equity / Total Assets
Learn more about determining equity percentage.
When offering stock options, it’s a good idea to provide a range for your workforce so they can choose what works best for them. This means offering a choice between a high percentage of equity and a lower salary or a lower stock percentage and a higher salary amount.
Tax Benefits of Sharing Equity
Employees who choose to accept equity in a company, and become stockholders, can realize a taxable employment benefit. This tax benefit is equal to the difference between the fair market value of the shares at the point of the employee’s acquisition and that of the amount paid for them. These shares and deductions must be accounted for on a person’s income tax return and the employee’s T4 slip.
Overall, whether you choose to offer equity to your employees or just pay them on a wage or salary, you will need the right tools to help you track such things. QuickBooks accounting software can help keep an expert eye on your business’ finances, no matter how you end up compensating your employees for their hard work.
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