Equity compensation

Not all private companies offer equity to their employees, but many do – especially startups and scale-ups. Regardless of whether equity awards make up a large or small portion of your employee compensation packages, it’s important to understand how they work so you can develop an effective compensation strategy. 

In this article, we’ll explain what equity compensation is, how it works and the different types of equity startup leaders can offer to their teams. 

What is equity compensation?

Equity compensation is a non-cash element of overall compensation and benefits, offering employees and other service providers an ownership stake in the company they’re working for. Types of equity-based compensation that European startups may issue to employees, advisors and other contributors include:

• Share options

• Restricted stock units (RSUs)

• Growth shares

• Bons de souscription de parts de créateur d’entreprise (BSPCEs)

Company shares can increase in value as your company grows. By offering equity at an early stage, you can align the interests of different stakeholders with the success of your business. This type of compensation is also useful for attracting and retaining talent – especially if you have limited cash flow.

How does equity compensation work?

While a payslip is pretty self-explanatory, equity compensation plans can be more complex and involve several key considerations: 

Equity grant

A grant is an agreement providing equity – or the right to obtain equity in the future – to the grantholder. Employees or other service providers who receive equity are given a formal document (such as a ‘notice of option grant’ or a ‘grant agreement’) outlining important details about their award, including:

• Grant date

• Number of options, shares or warrants issued

• Vesting schedule

• Exercise conditions

• Exercise price

Recipients will need all of this information to make informed decisions about their equity – such as whether to exercise their options – and understand the tax implications.

Vesting 

Vesting is the process of earning equity over a period of time or at specific milestones (e.g. performance metrics). This can help companies increase employee retention or motivate high performance.

A typical time-based vesting schedule is four years with a one-year cliff. In this case, the grantholder won’t earn any of their equity unless they stay at the company for a year – at which point 1/4 of their grant would vest. They would need to stay for all four years to be entitled to the full amount of shares. 

Exercising

An option grant represents the right to buy shares at a predetermined price, known as the exercise price or strike price. It does not automatically transfer any equity to the recipient.

In order to own actual company shares, the grantholder must exercise their options. In most cases, this can only happen within a specified period, known as the “exercise window”. However, some companies allow early exercising under certain conditions. Keep in mind that early exercising can impact how the options or shares are taxed.

Taxes on equity compensation 

Tax implications for employee equity vary based on the security type and share scheme. For instance, UK employees who receive share options through the Enterprise Management Incentive (EMI) scheme or the Company Share Ownership Plan (CSOP) don’t have to pay income tax or National Insurance contributions on their grant. However, selling their shares may incur capital gains tax (CGT).

Other types of equity – such as unapproved options, restricted stock units (RSUs) and growth shares – are less tax-efficient.

Different types of equity compensation

Share options

Share options offer employees the right to buy shares at a fixed price in the future. Approved options (i.e. options issued through government-approved schemes like EMI or CSOP) offer tax benefits for both companies and employees. 

For startups that have outgrown or don’t qualify for these schemes, unapproved options can be a good alternative. They work in a similar way, but are more flexible and less tax-efficient than approved options.

Restricted stock units (RSUs)

Unlike options, RSUs are granted as shares and don’t need to be exercised. However, employees can only take full ownership of these shares if certain conditions are met – such as a vesting schedule and/or a company liquidity event.

Typically, RSUs don’t cost anything until they vest, at which point they’re treated as taxable income.

Growth shares

Some UK companies that have outgrown EMI and CSOP choose to issue growth shares to their employees – either as a taxable benefit or for an upfront cost. Receiving growth shares allows employees to benefit from future growth in a company's value. The “growth” depends on a specific valuation hurdle; a sale above the hurdle triggers the growth shares to become valuable.

Growth shareholders only pay income tax on their equity if it’s issued for “free” or at a discount to market value. Any profit they make when selling their shares may be charged as capital gains tax.

BSPCEs

BSPCEs are the most popular type of employee share ownership plan (ESOP) in France. These grants are similar to share options, giving employees the right to buy a set number of company shares in the future for a specified strike price. 

French companies can also issue stock options to employees, but the plan conditions and tax treatment are different from BSPCEs.

Equity compensation on Carta

Sourcing relevant benchmarks, consulting with peers, searching through old spreadsheets; managing compensation in a growing business is not easy.

With Carta, you can leverage trusted benchmarks to create and implement an effective compensation strategy at any size. Benefit from a connected solution that joins the dots from negotiating compensation packages through to onboarding employees and issuing grants.

And with built-in support for different locations and currencies, you can enjoy better compensation management with Carta, wherever you’re based.