The 10 Different Types of Equity Compensation

By: AJ Ayers, CFP®

At BKFi, we understand that equity compensation isn't just a part of your salary—it's an essential part of your financial future and the key to unlocking financial independence. With the variety of equity compensation methods available today, understanding their distinct features, benefits, and implications can often feel overwhelming. That's why we are here: to unravel the complexities, elucidate the choices, and guide you to decisions that best align with your financial goals.

In this, we comprehensively explore the ten different types of equity compensation. From Incentive Stock Options and Non-Qualified Stock Options to lesser-known options like Phantom Stock and Profits Interests in LLCs, we dissect each type to its core. We look at their unique attributes, their tax implications, and how they can shape your financial journey.

1. Incentive Stock Option (ISO)

In equity compensation, one form stands out for high-achieving employees: Incentive Stock Options (ISOs). These options allow individuals to purchase company shares at a predetermined price. ISOs can only be granted to employees. This price, called the exercise price, is equal to the fiar market value on the day of the grant. ISOs are typically granted at the early stages of a company when the valuation and price of the stock is low with massive potential for growth. 

Employees must hold onto their ISOs for a specified period (two years from grant, and one year from exercise), as this can result in favorable tax treatment. If the holding requirements are met, the tax benefits help maximize the value of ISOs compared to other types of equity compensation, such as non-qualified stock options. While exercising ISOs does not immediately trigger income tax, it often will lead to the employee owing Alternative Minimum Tax, or AMT. 

2. Non-Qualified Stock Option (NQO)

Non-Qualified Stock Options (NQOs) are a more flexible cousin to the Incentive Stock Option (ISO). 

NQOs are an equity award that allows employees, and sometimes other stakeholders like consultants, to buy company stock at a predetermined price. Unlike ISOs, which are limited to employees, NQOs can be offered more broadly within the company. This flexibility makes NQOs a popular choice for companies looking to incentivize a broader range of contributors.

While NQOs and ISOs share some similarities, they differ in tax treatment. When exercising NQOs, employees will need to pay income tax on the difference between the grant price and the fair market value price of the exercised option on the day of exercise so typically employees will exercise and sell their NQOs on the same day. 

Essentially, NQOs allow you to purchase a certain number of shares at a fixed price per share, as defined in your equity award agreement. You are not obligated to buy the stock; it is an opportunity for potential growth if the company performs well.

3. Restricted Stock Unit (RSU)

As opposed to other types of equity compensation, RSUs add a level of certainty to the process. The value of RSUs remains tied to the company stock, so even if the stock price fluctuates, their worth remains constant until the vesting period is over. There is no need to purchase company shares at a discount like you would with other stock options, such as Employee Stock Purchase Plans (ESPPs).

Vesting requirements vary depending on the company's policies. For example, employees might need to work for a set number of years or achieve specific performance targets. Once the employee fulfills these conditions, they can receive the company stock or a cash payment of equal value. This mitigates the risk of employees leaving the company before their RSUs have vested, incentivizing them to stay and grow their partnerships.

RSUs are just one of the many forms of equity compensation but are particularly favored for their simplicity and stability. Comparing them to other equity compensation methods like stock options, RSUs don't require employees to buy company stock at a discounted price or decide when to exercise their option.

4. Performance Shares

Performance shares are company shares awarded to employees through an equity compensation plan but with a twist. Unlike stock options or restricted stock units (RSUs), the vesting of these shares is not only time-based but also tied to the company's performance or the employee's individual targets. It's like the corporate equivalent of "you reap what you sow."

Now, why would an employer offer equity in the form of performance shares? The answer is simple: to align the interests of the employees with the company's goals. By tying the value of your equity to the company's success, employees are encouraged to perform at their best, ultimately benefiting both the company and the employee.

So, how does this equity compensation benefit the employee? Firstly, performance shares can enhance the overall compensation received by the employee. When the company performs well, employees can receive more shares than they would with a traditional stock option agreement. Secondly, it motivates employees to work harder and smarter, knowing that their efforts directly impact the value of their equity compensation.

Keep in mind that performance shares also come with some risks. If the company doesn't meet its targets, employees may end up with fewer shares or even none at all. Consequently, weighing the potential rewards against the risks is essential when evaluating this type of equity compensation.

5. Employee Stock Purchase Plan (ESPP)

An Employee Stock Purchase Plan allows employees to purchase shares of the company's stock at a discount, typically through after-tax payroll deductions. This means employees get the chance to invest in their company for a certain period and enjoy the benefits of owning company stock at a lower price. 

There are two main types of stock purchase plans: qualified and non-qualified. Qualified ESPPs are the most common and resemble qualified retirement plans in some ways. Although the specifics can vary, qualified ESPPs typically come with features like a vesting schedule, which means an employee must work for the company for a certain period before fully exercising their purchase rights.

One of the appealing aspects of ESPPs is that they offer a straightforward way to own company stock. Unlike some more complicated equity compensation forms, ESPPs involve simply deciding how much money you'd like to set aside (within a limit) to purchase shares. Your employer will deduct the designated amount from your after-tax paycheck, making the process relatively hassle-free.

6. Stock Appreciation Rights (SARs)

SARs give employees the right to increase the value of a specific number of company shares over a predetermined period. The key advantage of SARs is that employees don't have to purchase any stock or exercise any options to reap the benefits. Instead, they receive the appreciation in the company's stock price in cash or shares, depending on the agreement.

When the predetermined period ends, and if the company's stock price has risen, employees receive the difference between the initial market value of the stock and the fair market value at the end of the period. This allows employees to participate in the company's growth without directly dealing with stocks or facing the financial risks associated with stock ownership.

For example, imagine you're granted 1,000 SARs for your company's stock at a predetermined initial value of $50 per share; when the SARs vest, the company's stock price has risen to $75 per share. You would then be entitled to the appreciation of $25 per share ($75 - $50) multiplied by 1,000 SARs, resulting in a $25,000 payout.

7. Phantom Stock

Unlike stock options, phantom stock is a deferred compensation plan that allows plan participants to benefit from a company's share price upside without actually receiving company shares. In essence, it is a promise to pay a future cash bonus equal to the value of the increase in the value of a certain number of shares.

Phantom stock can be an attractive alternative for companies that wish to reward their employees with compensation tied to the stock price without diluting their ownership. Typically, phantom stock plans are used for upper management but may also be extended to other key employees. The value of the phantom stock correlates with the company's stock price, allowing employees to share in the growth and success of the business.

One critical aspect of phantom stock plans is the vesting schedule. This schedule determines when employees can redeem their phantom stock for cash, keeping them engaged and motivated to stay with the company long-term. Various factors, such as time-based milestones or performance achievements, could be implemented within the vesting schedule.

In addition to the vesting schedule, phantom stock plans usually have a predetermined grant date and specific payout conditions. For instance, the payout could be tied to the employee's retirement, a change in control, or other predefined events. These conditions offer companies the flexibility to structure their phantom stock plans as they see fit for the business's needs.

8. Restricted Stock Award (RSA)

You're given company shares on the grant date when you receive an RSA. This means you officially become a shareholder at that point. However, the catch is that these shares come with a vesting schedule, determining when you can claim full ownership of the stock. The vesting schedule typically spans several years and may be tied to performance or tenure milestones within the company.

One thing to keep in mind is that RSAs are subject to taxation. Since you're considered a shareholder from the grant date, you'll need to pay taxes on the fair market value of the shares when they're granted. This tax obligation may be deferred until vesting, depending on the terms of your specific RSA agreement.

9. Direct Stock Ownership

In direct stock ownership, employees receive shares of the company they work for, either as a bonus or through a purchase. This elegantly practical approach allows employees to have a direct stake in the company's success. The more successful the company becomes, the more valuable the shares employees own, aligning their interests with the company's goals.

Offering company shares as part of an employee equity compensation plan can be a powerful way to incentivize and reward employees. Not only does direct stock ownership empower employees to play a more significant role in the company's growth, but it can also encourage a sense of team spirit and collective responsibility. This way, employees appreciate a stronger connection with the company and take pride in their collective achievements.

Direct stock ownership can also benefit employees through elective deferral contributions. By deferring a portion of their salary, employees may take advantage of favorable tax treatment on their stock ownership. This can be an incredibly efficient method for wealth creation, especially for those in high-income tax brackets.

10. Profits Interests in LLCs

Profit interests are a unique equity award given to employees of a limited liability company (LLC). They represent a share in the future appreciation of the company rather than a direct ownership stake in the current value of the LLC. Unlike other equity awards, such as capital interests or company shares, profits interests solely focus on the return on equity that the employee might achieve as the LLC grows in value.

Using profits interests in LLCs provides several benefits for the employer and the employee. For one, employees who receive profits interests are motivated to contribute to the company's success, as their financial rewards will be directly linked to the growth of the organization. From the employer's perspective, offering profits interests is often a tax-efficient way to compensate top talent, especially when structured correctly.

Regarding equity compensation in LLCs, different options are available, including capital interests, equity options, and phantom equity. Each has merits and drawbacks, depending on the company's specific needs and preferences. Many LLCs favor profit interests since they primarily focus on future growth and essentially reward employees for their role in driving the LLC's success.