Equity Compensation Plans

Nick

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Nick Hearne

Financial Advisor & Associate Portfolio Manager

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Background

Equity compensation is a non-cash benefit that may be awarded to an employee. This form of compensation provides a variable and potentially lucrative component to a pay package. Equity compensation plans can take several forms with differing rules and characteristics.

One commonality they all share is that their value is tied to the company’s share price. This aligns the goals of the employees with the goals of the company, which can lead to increased performance, and improve the profitability of the firm. Equity compensation is especially popular with start-up companies, who may lack the cash flow required to compensate high-quality employees through salary and bonus.

Companies may use different names for their plans. Furthermore, the plan’s specifications can be unique to each employer, so that one plan may not be the same as a plan with the same name at a different employer.

Common Equity Compensation Plans

Employee Stock Options (ESOs)

Employee Stock Options (ESOs) provide an employee with the right, but not the obligation, to purchase shares of the employer’s company at a set price (exercise price) within a defined timeframe. ESOs that meet certain requirements qualify for a deduction that results in the benefit being effectively taxed at capital gains tax rates. One of these requirements is that the exercise price cannot be less than the fair market value (FMV) of the share when the ESO is granted. The implication is that if the company’s share price does not appreciate, the ESO will expire worthless. However, a significant appreciation in share price can be very lucrative for an employee.

Restricted Shares Units (RSUs)

Restricted Share Units (RSUs) are notional units that mirror the market value of the employer’s common shares. The RSUs require the employee to achieve pre-determined requirements in order to receive the underlying shares (or an equivalent cash benefit). A general requirement is for the employee to remain with the company for a certain period of time (vesting period). This vesting period is typically within three years to avoid triggering salary deferral arrangement (SDA) rules. While RSUs contain less upside potential than an employee stock option, they can still have value without appreciation in share price.

Performance Share Units (PSUs)

Performance Share Units (PSUs) have a very similar structure to Restricted Share Units (RSUs), but with a focus on employee and/or company performance. The typical vesting period for PSUs is three years (to avoid triggering SDA rules), incentivizing employee performance over a medium time horizon. Once the PSUs have vested, employees will receive the underlying shares if they’ve achieved the specified performance targets. If the performance targets are not met, the shares are forfeited to the company.

Deferred Share Units (DSUs)

Deferred Share Units (DSUs) are notional units that mirror the market value of the employer’s common shares. Companies offer DSUs to incentivize employee performance over a long time horizon. To avoid triggering SDA rules, benefits derived from DSUs must be received after the time of the employee’s death, retirement, or termination of employment and before the end of the following calendar year. DSUs can generally be redeemed for either company shares or cash.

Share Appreciation Rights (SARs)

Share Appreciation Rights (SARs) provide a similar benefit to employee stock options. A SAR entitles an employee (once vested) to receive a benefit equivalent to the increase in the company’s share price between the grant date and the vesting date. SARs do not require employees to pay an exercise price and are typically subject to similar provisions as Restricted Share Units.

Phantom Stock Plan

A Phantom Stock Plan enables an employer to compensate employees with equity-based compensation without having to transfer ownership interest. A Phantom Stock Plan is not defined for income tax purposes. Companies may refer to their Deferred Share Unit (DSU) Plan as a Phantom Stock Plan. Phantom Stock Plans generally refer to agreements where employees receive a cash benefit that is directly tied to the value of the shares of the company.

Employee Considerations

The appeal of equity compensation from an employee perspective is dependent on a combination of factors.

An employee’s opinion on the company’s future prospects will strongly influence their desire for equity compensation. Employees anticipating significant appreciation in share price may be attracted to employee stock options that offer significant upside potential. Employees with a negative outlook on the company’s prospects may value higher cash-based compensation (eg. salary) instead of equity-based compensation.

Employees should also consider how long they plan to stay with a company. Equity compensation would not typically provide value to an employee planning to leave before the benefit vests.

Risk tolerance is another important factor and is unique to each individual. Employees with a higher risk tolerance will be more comfortable with the variable and uncertain nature of equity-based compensation.

An employee may be in a position to decide how their compensation is structured. This opportunity may arise from their employer engaging them in a collaborative process when designing their compensation structure. Alternatively, an employee may need to decide between two jobs, one with a higher salary and the other with a lower salary but an equity compensation component. Individuals may benefit from collaborating with an independent financial planner to determine the best path for their unique situation.

This article is meant to provide a general overview and is not intended to provide tax or legal advice. You should consult with professionals to ensure that your own unique circumstances have been considered and any action taken is based on the latest information available.

 


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