How does equity compensation work in a private company?

Introduction

Equity compensation is a common practice in private companies, allowing them to attract and retain talented employees by offering them a stake in the company’s ownership. In this article, we will dive deeper into how equity compensation works in a private company, exploring the different types of equity compensation, vesting schedules, tax implications, and more.

Types of Equity Compensation

Stock Options: Stock options are a common form of equity compensation in private companies. They give employees the right to purchase company stock at a predetermined price, known as the exercise price or strike price. Typically, there is a vesting period before the options can be exercised, allowing employees to buy shares at the strike price.

Restricted Stock Units (RSUs): RSUs are another popular form of equity compensation. With RSUs, employees receive virtual shares that convert into actual shares upon vesting. Unlike stock options, RSUs do not require employees to purchase shares. Instead, they are granted shares outright once the vesting period is complete.

Employee Stock Purchase Plans (ESPPs): ESPPs allow employees to purchase company stock at a discounted price. Employees contribute a portion of their salary to the plan, and at regular intervals, the accumulated funds are used to buy shares at a discounted price.

Vesting Schedules

Equity compensation typically comes with a vesting schedule, which determines when employees can exercise their equity rights. Vesting schedules are designed to incentivize employees to stay with the company for a certain period. Common vesting schedules include:

Cliff Vesting: In cliff vesting, employees become fully vested in their equity after a specific period, often one to four years. Until the cliff period is reached, employees have no ownership rights.

Graded Vesting: Graded vesting allows employees to gradually become vested in their equity over time. For example, an employee may become 25% vested after one year, 50% vested after two years, and so on.

Tax Implications

Equity compensation can have tax implications for both the company and the employees. It’s important to consult with tax professionals to fully understand the tax consequences in your specific jurisdiction. However, here are some general considerations:

Stock Options: When employees exercise stock options, they may be subject to ordinary income tax on the difference between the fair market value of the shares at the time of exercise and the exercise price. If they hold the shares for a certain period, they may also be subject to capital gains tax upon selling the shares.

RSUs: RSUs are typically taxed as ordinary income when the shares are delivered to the employee. The fair market value of the shares at that time is subject to income tax.

ESPPs: The discount received through an ESPP is generally considered ordinary income and subject to income tax. Any gains from selling the shares may also be subject to capital gains tax.

Conclusion

Equity compensation is a valuable tool for private companies to attract and retain talented employees. Stock options, RSUs, and ESPPs are common forms of equity compensation, each with its own unique features. Vesting schedules determine when employees can exercise their equity rights, and tax implications should be carefully considered. By understanding how equity compensation works in a private company, both employers and employees can make informed decisions.