Equity Based

Compensation
Consider the following example
A start-up made the following deal with its Chief Technology
Officer. The salary was approximately 35% below his market rate
as a chief technology officer (CTO). The low salary was being
offset with a reasonable chunk of equity.

What type of compensation is this?

What is Equity Based Compensation
• Equity compensation is a form of non-cash payment that grants
employees partial ownership of the company through stock shares.
The company can either grant employees these shares of stock or
give them the option to purchase shares at a discounted rate. 
• Equity compensation is a strategy used to improve a business's cash
flow. Instead of a salary, the employee is offered a partial stake in
the company. Equity compensation comes with certain terms with
the employee not earning a return at first.
• Startups often lure in star employees with the promise of equity.
Why? A lot of startups are short on cash but can issue shares at will
and have equity to hand out.
What is Equity Based Compensation
• Usually, companies don’t give employees stocks immediately upon hiring them;
instead, there’s often a vesting period or vesting schedule involved.
• Under a vesting schedule, employees earn their stock options or shares over a
set period of time instead of all at once. For example, with a four-year graded
vesting period, employees would receive 25% of their promised equity
compensation after one year.
• Vesting periods help retain employees for longer periods of time, encouraging
people to stay with the company at least until their stocks fully vest. After
equity vests, employees have full ownership and rights to their stocks or stock
options — the right to purchase shares. If employees hold onto their shares,
they’re eligible to earn dividends based on the company’s profits or
performance on the stock market. Otherwise, employees can choose to sell their
shares just as they could any other stocks they own.
• Some companies may offer equity as part of their total employee
compensation package as a way to offset a lower base salary.
Vesting Schedule
• time-based,
• milestone-based, and
• a hybrid of time-based and milestone-based
Vesting Schedule
Time Based
• Employees earn options or shares over a specified period of
time.
• Most time-based vesting schedules have a vesting cliff.
• Cliff vesting is when the first portion of the option grant vests on a
specific date and the remaining options gradually vest each month or
quarter afterward.
• Many companies offer option grants with a one-year cliff to
motivate employees to stay for at least a year. If employees
leave before the one-year mark, any unvested options are put
back into the employee option pool.
Vesting Schedule
Milestone Vesting
• Employees earn the options or shares after a specific milestone.
• Other than IPO, milestones could be completing a project,
reaching a business goal, or hitting a certain valuation.
• Milestone-based vesting isn’t as common as time-based vesting.
Vesting Schedule
Hybrid vesting
• is a combination of time-based and milestone vesting.
• This model requires employees to simultaneously work at the
company for a certain amount of time and hit one or more
milestones to receive their options or shares.
Vesting Schedule Example
Meetly, Inc. (a hypothetical company) hired Blake on January 1,
2020. As part of the  compensation package, Meetly gave Blake an
option grant with the following details:
• Grant date: 1/1/2020
• Options granted: 192
• Vesting schedule: Time-based; monthly for four years with a
one-year cliff
Vesting Schedule Example
One year after Blake’s hire date, on January 1, 2021, she reached
the vesting cliff and 1/4 of the shares (48 shares) vested. At that
time, Blake could have exercised those 48 shares (though she
wasn’t obligated to). 
Over the next three years, an additional four shares vest every
month. By January 1, 2024, Blake’s options will be completely
vested, and she can exercise all 192 of the shares in the option
grant if she chooses. 
Vesting Schedule Example
Date Options vested Cumulative
1/1/2021 48 48 (192/4 = 48)
1/1/2022 48 96
1/1/2023 48 144
1/1/2024 48 192

If Blake leaves the company before January 1, 2024, she will

surrender all unvested shares, which will be returned to the
company’s option pool.
Exercise on Vested Stocks
Grant Date: January 1, 2020
Number of Shares: 10,000
Vesting Schedule:
• Four-year vesting schedule
• One-year cliff
• 1/36 of the remaining shares vest monthly thereafter
Scenarios
Employee leaves after 6 months
Employee leaves one year
Employee leaves after 30 months
Employee stays forever
Exercise on Vested Stocks
Employee leaves after 6 months
• In this scenario, if an employee leaves after six months of
service, zero shares would have vested.
• This is because of the ‘one-year cliff’. Essentially, if the
employee does not stay a minimum of one year, then they
are not entitled to any of the option shares.
Exercise on Vested Stocks
Employee leaves one year
• In this scenario, the employee would have earned 2,500
shares.
• This is because one year is 25% of the vesting schedule, thus
earnings 25% of the option shares.
Exercise on Vested Stocks
Employee leaves after 30 months
• In this situation, 6,250 shares would have vested.
• This is because the employee would have earned 2,500
shares after year one, which leaves 7,500 remaining shares.
The employee stays for another 18 months out of the
remaining 36 months, which means they would have earned
1/2 (18/36 = 1/2) of the 7,500 shares, or 3,750 shares.
• 2,500 + 3,750 = 6,250 shares vested.
Exercise on Vested Stocks
Employee stays forever
• In this situation, the employee would have had the
full 10,000 shares vest.
How is Equity Paid
• The two main types a company usually provides are:
• vested equity and
• granted stock upfront.
• With vested equity, payments are made over a set number of
increments pre-determined when you sign a contract.
• Granted stock is provided at the beginning of the contract.
Although the equity offer is significant, there's always risk
involved with accepting equity in place of a salary.
Commonly Used Forms of Equity
Compensation
• Stock Options: A stock option gives the holder the right to purchase a share of
company stock at a particular price for a set period of time, usually 10 years. The
price at which the options may be "exercised" is usually the price of the
company's stock on the date the options are granted. If the company performs
well, the stock price will increase over the exercise price, giving the options value
and rewarding the executive for his role in the company's success. Typically, such
options may not be exercised for a period of time, usually between one and five
years, before they "vest," or can be exercised.
• Restricted Stock: Shares of company stock which, despite being awarded as
compensation, are not sellable by the recipient until a vesting schedule is
completed. Although unable to sell shares of Restricted Stock before the vesting
schedule is complete, owners enjoy all the other benefits of stock ownership, such
as voting rights and dividends. If the executive leaves before the stock vests, the
stock is forfeited. Restricted Stock is taxed on the amount received on the vesting
date based on the closing market value of stock price.
Commonly Used Forms of Equity
Compensation
• Restricted Stock Units (RSUs) are a similar performing compensation tool as Restricted Stock
RSUs represent a promise by an employer to pay an employee a certain number of company
shares upon the completion of a vesting schedule and offer several distinct advantages
compared with Restricted Stock. First, employers can issue RSUs without diluting the share
base. Second, in issuing RSUs company administrative costs tend to be lower because there are
no actual shares to issue, hold, record, and track. And third, RSUs can make tax deferrals easier
by simply delaying actual share issuance. Because RSUs represent a promise of future shares,
owners of RSUs do not enjoy any rights of stock ownership.
• Performance Shares: Shares of company stock awarded over a performance period if specific
performance measures are attained. There are two types of performance measures: performance
conditions and market conditions. Performance conditions are financial goals, like earnings-per-
share or return-on-equity. Market Conditions on the other hand compare company performance
to the market or a segment of the market, for example, total shareholder return v. peers.
Performance periods are typically three years in duration with grants made on an almost annual
basis resulting in overlapping performance periods. Performance shares receive differing
accounting treatment depending on whether they are settled in cash or stock and whether they
are a market or performance condition.