Equity is often a significant element of compensation in the technology industry. It has a long history in Silicon Valley: companies dating back to the 1950’s rewarded employees with ownership stakes. Equity aligns the interests of workers and managers with those of investors. In this post we look at some of the reasons why both companies and their employees benefit from equity compensation.
This post is adapted from the second chapter of Equity Compensation for Tech Employees. The book is focused on helping individuals manage their equity awards to achieve their financial goals. Conversations about stock compensation tend to be dominated by founders (who hold extremely undiversified portfolios) and investors (who are quite diversified). These groups face different considerations than ordinary employees. Employees sit somewhere in between, with each stint at a company being an investment in both its success and our own financial future.
Why Companies Grant Equity
Why would a company choose to pay employees with equity? The most commonly cited reason is to align employees with the company’s goals. Equity compensation means employees benefit from the firm’s long-term performance. Workers at tech companies are routinely asked to work on risky projects. They are more willing to do this if they are compensated for helping the company’s bottom-line. Holding equity gives them a financial motive for helping to grow the business.
Equity tends to pay off especially well for the earliest employees (if the company has a successful liquidity event — which is a big if for an early-stage company). This incentivizes joining a company early, while it is still a risky venture. The award then vests over several years. This motivates employees to stay at the company in order to benefit. However, liquidity events tend to take 8-12 years after the founding of a company. This means that early employees have illiquid equity for a long period of time. That is one trade-off to consider when joining a startup.
It is also better for a company’s balance sheet to pay with equity instead of cash. Salaries and cash bonuses are expensive. Granting shares costs a company much less. It can manufacture the shares. This dilutes the company’s other shareholders but saves them cash. Raising cash would also cause dilution, after all. (See Chapter 4 for a discussion of dilution.) In effect, equity compensation pushes risk onto employees. An equity award makes you an investor in the company, at the cost of lower cash compensation
Why Employees Like Equity
It may seem obvious that employees like being compensated in equity. After all, many people in our industry have benefited from these awards over time. It is not obvious that equity compensation would benefit employees, though. After all, many of the highest growth companies in our industry are publicly traded. Anyone can invest in companies such as Apple, Amazon, and Alphabet. So why do employees like getting compensated with equity
The first reason is the risk / reward trade-off. Joining a technology company, especially early in its lifecycle, carries substantial risk. Leaving a stable company for a startup requires the potential for greater upside. Equity provides a way to achieve this. If you are excited about a startup, you are probably excited about its growth prospects. This makes you willing to take on more risk in order for a possible payoff if things go well.
Another reason for preferring equity compensation is its favorable tax treatment. Additional cash compensation has a decreasing marginal value. The ability to earn equity and be taxed at long-term capital gains rates can seem much more favorable. However, proposed changes to the tax code may undermine this benefit. This is also less true of equity compensation after a company has already experienced a liquidity event.
How to Manage Equity Wisely
Employees should be aware of two significant risks associated with employer equity. First, if you hold equity in the same company you work for, you are at increased risk. If the company declines or goes out of business you could lose both your investment and your salary. Second, equity grants leverage a psychological bias known as the endowment effect. The endowment effect means that we value things higher once we own them than we do beforehand. In other words, if your employer gave you $1,000 in cash you probably would not spend it all on stock in the same company. If you are granted the same dollar amount in equity there is a good chance you will hold onto it, though. Reframing the decision as an active rather than a passive one can help you avoid this bias.
Software engineers, data scientists, product managers, and designers all commonly receive equity awards. Early-career employees may hold much of their net worth in a single company. Senior employees may receive more than half of their compensation in the form of equity. Regardless of where you are in your career, it is not too early — or too late — to learn how to manage your equity. Check out the book learn more about specific types of equity awards, how to manage your investment strategically, and what to do during and after a liquidity event.