11 Helpful Tips To Know For Your Equity Incentive Plan

In the realm of employee compensation, companies often employ various strategies to attract, motivate, and retain top talent. One such strategy is the implementation of an Equity Incentive Plan (EIP). Equity plans can offer significant advantages for both employees and employers. EIPs can fostering a shared sense of ownership and aligning interests for long-term success. In this blog post, we will delve into what an Equity Incentive Plan entails and share 11 indispensable tips to help you navigate this complex terrain.

1. Understanding What Is A Equity Incentive Plan

An Equity Incentive Plan (EIP) is an equity compensation program designed by companies to offer employees the opportunity to acquire or receive shares of company stock. This acts as a form of long-term incentives or rewards. It is a strategic approach to aligning employee interests with the company’s overall success and long-term goals. By granting employees ownership in the company, an EIP aims to motivate and retain top talent. Further, it will also foster a sense of ownership and commitment, and create a shared sense of purpose.

2. Types of Equity Incentive Plans

There are many different types of equity incentive plans, each with its own advantages and disadvantages. Below I listed some of the most common to be aware of. But before you dig in, keep in mind that both public companies and private companies can customize equity incentive plan to suit their specific needs and objectives such as having different vesting schedules or exercise periods. You may need to reach out to your financial advisor or service provider for customize solutions or questions related to your EIP.

Stock Options: Stock options grant employees the right to purchase company stock at a predetermined price (known as the exercise price or strike price) within a specified period. There are two main types of stock options:
- Incentive Stock Options (ISOs): ISOs are typically offered to key employees and have tax advantages. They are subject to specific rules under the Internal Revenue Code in the United States.
- Non-Qualified Stock Options (NQSOs): NQSOs are more flexible than ISOs but lack some of the tax advantages. They are often granted to a broader range of employees.
Restricted Stock Units (RSUs): RSUs represent a promise to deliver company stock to employees at a future date or upon meeting certain conditions. Unlike stock options, RSUs do not require employees to purchase shares but provide them with actual stock units.
- Time-Based RSUs: These RSUs vest based on a specific time period, such as four years with a one-year cliff (meaning no vesting occurs until the first anniversary).
- Performance-Based RSUs: These RSUs vest upon achieving predetermined performance targets, such as revenue goals or stock price milestones.
Employee Stock Purchase Plans (ESPPs): ESPPs allow employees to purchase company common stock at a discounted price. Employees contribute a portion of their monthly salary to this employee stock option plan, and at specific intervals (often six months), they can use those contributions to buy company shares at the lower price.
Phantom Stock: Phantom stock plans provide employees with hypothetical units or rights to receive cash or stock equal in value to the company’s actual shares. Unlike RSUs, phantom stock does not confer actual ownership but entitles employees to receive the equivalent value upon meeting specific conditions.
Stock Appreciation Rights (SARs): SARs give employees the right to receive the appreciation in the company’s stock value over a specified period. When exercised, employees receive either cash or company stock equivalent to the increase in value.
Performance Share Units (PSUs): PSUs are similar to RSUs; however, PSUs are granted based on achieving predetermined performance goals. Employees receive a specified number of shares if performance goals are met.

3. Aligning Interest

Equity incentives align the interests of employees and shareholders, fostering a sense of ownership and commitment. Employees’ success is tied to the company’s success. The company tries to align interest by motivating employees to work towards increasing shareholder value and are rewarded via their compensation package. So for instance, if an employees’ EIP is tied to the company’s value, they are more likely to also want to see the company’s value increase as the employee will also benefit financially.

4. Vesting Periods

Equity grants typically have vesting periods, during which employees must remain with the company to earn their shares. Vesting schedules can be time-based such as 5-years with a one-year cliff, or it can be milestone-based such as achieving specific performance targets. Below are some key items to consider when trying to understand vesting periods.

Duration. Vesting intervals are commonly expressed in years. Although shorter or longer durations may also be used the typical vesting period is three to five years.
Vesting Schedule. The vesting schedule is going to help the employee understand when/how the equity will be granted over time. There are two types of Vesting schedules: Time-based Vesting and Milestone-Based Vesting. Each are important to understand when the grant date for your EIP is.
- Time-Based. Under Time-Based, equity gets granted incrementally over a specific period. For example, over a 5-year period with one-year cliff (discussed next) means that no equity vests until the employee finishes one full year of employment in which 20% of the equity is granted. Afterwards the equity vest annually or whichever the employment contract states.
- Milestone Based. In some cases, equity grants may vest based on the achievement of specific milestones or performance targets. Milestone-Based vesting can be relevant for employees involved in projects with clear objectives or performance-driven roles.

Vesting Period, Vesting, Time, Duration, Vesting Schedule, Time Based vesting, Milestone based vesting, Cliff Vesting, Accelerated Vesting, Unvested Equity

Cliff Vesting. A cliff vesting period is a specific provision within a vesting schedule where a significant portion of the equity grant vests all at once after a specified period. This could be at the end of the first year or any other predetermined timeframe. If an employee leaves the company before the cliff vesting period is completed, they typically do not receive any equity.
Accelerated Vesting. Accelerated vesting may occur under certain circumstances, such as a change of control event such as a acquisition or merger or a significant company milestone. Accelerated vesting allows employees to gain ownership of their equity grants more quickly than the original schedule outlined in the plan.
Forfeiture of Unvested Equity. If an employee leaves the company before the vesting period is completed, they typically will forfeit any unvested equity. Because of this, it will usually create an incentive for employees to stay with the company until they are fully vested.

Taxes, Stock Options, Phantom Stock , RSUs, Tax Impacts From Selling, Alternative Minimum Tax, AMT

5. Impact on Taxes

Understanding the tax treatment of equity incentives is crucial. Taxation may vary depending on the type of equity grant, the holding period, and the employee’s jurisdiction. Seek professional advice to optimize tax planning strategies and to understand their respective tax consequences. That said, here are some common tax considerations related to EIPs.

Tax Impacts From Your Vesting Period
- Stock Options: For a Non-Qualified Stock Options (NQSOs), the difference between the fair market value of the stock at exercise and the exercise price is generally subject to ordinary income tax. This is known as the Spread, which is treated as compensation and is subject to income tax withholding. Separately, taxes for Incentive Stock Options (ISOs) can vary. There is typically no tax at exercise for ISOs, but the Spread may be subject to an Alternative Minimum Tax (AMT) when the stock is sold.
- Phantom Stock and RSUs: Phantom Stock and RSUs are typically subject to ordinary income tax at the time of vesting based on the fair market value of the stock or its equivalent on that date.
Tax Impacts From Your Selling: When you sell your Stock Options, Phantom Stock, or RSUs the difference from the value you sell it at and the fair market value is subject to capital gains tax. If you held the stock options over 1-year, you may qualify for long-term capital gain taxes. Check out our article on “Are Stocks Capital Assets” to learn more about capital gain taxes.
Alternative Minimum Tax (AMT): In some cases, employees may be subject to AMT on certain equity grants, such as ISOs. AMT is an additional tax calculation that applies to certain types of income, including the spread on ISO exercise, and can result in higher overall tax liability.

6. Valuation and Exercise Price

When granting equity, companies must establish a fair market value and exercise price. If you work for a private company, independent valuation experts often assist in determining these values, which impact the potential value employees can realize from their equity grants. These experts would consider various things, such as financial performance, industry benchmarks, and growth prospects to arrive at a reasonable valuation.

As an employee, you should also be aware of the potential dilution of existing shareholders’ ownership due to the issuance of new shares for equity grants. Employees should understand the ownership stake they will hold after their grants are exercised or vested.

What is the Exercise Price?

The Exercise Price is the predetermined purchase price at which an employee can purchase company stock when exercising their options. The option is In-The-Money when the fair market value of the stock is greater than the exercise price. Employees would be able to purchase shares in this scenario at a discount from the stock’s current market value by exercising their option. On the flip side, when an option is Out-Of-The-Money, it may not be profitable to exercise it. This is because the fair market value is less than the exercise price.

Keep on Eye on the Expiration Period

Importantly, employees should be aware of the expiration period of their options. If Stock Options are not exercised before the expiration date, employees will lose the opportunity to purchase the shares at the exercise price. Further, in some cases, equity grants may have specific conditions or restrictions regarding the timing they can be exercised. So employees should review their grant agreements to understand any additional provisions related to exercise timing.

7. Voting Rights

Voting rights associated with equity grants typically occur when employees have acquired and hold actual shares of the company’s stock. The specific timing and extent of voting rights can vary depending on the type of equity grant. This also includes the terms outlined in the grant agreement or applicable corporate bylaws.

8. Exit Strategies

In the event of a merger/acquisition, or IPO, equity incentives can provide significant financial rewards for employees. But, it is crucial to understand the terms and conditions regarding equity treatment during such events.

For instance, depending on the terms negotiated during the change of ownership, equity grants may be converted into the equity of the acquiring company. Or the new entity formed after the transaction. Employees may have the option to cash out their equity grants at a predetermined price or based on a valuation determined during the transaction.

This is why transparent communication and education about equity incentives are so important. Employers should provide clear explanations of the program’s details, potential outcomes, additional information, and any associated risks to ensure employees make informed decisions.

Diversification, Risk Mitigation, Exit Strategies

9. Diversification and Risk Mitigation

Although there are many benefits with having the opportunity to be part of a company’s Equity Incentive Plan, employees should consider diversifying their investment portfolios to reduce risk. Relying solely on equity grants from one company can expose individuals to concentrated risk.

The issue with concentrated risk is if your financial wealth is concentrated with one company. If that company faces financial difficulties or a significant decline in its stock value, it can have a substantial impact on the employee’s overall financial well-being. Diversification helps spread the risk across different investments and asset classes, reducing the potential negative impact of any single investment.

10. Employee Engagement and Retention

EIP are meant to be a powerful long-term incentive plan tool. EIPs are meant to increase employee engagement, to increase retention, and to reduce employee turnover. The company is trying to align employees’ interests with the success of the organization. This is meant to foster loyalty and commitment.

11. Evaluation and Benchmarking

Regular evaluation and benchmarking of equity incentive plans against industry standards and competitors can ensure that the program remains attractive, competitive, and aligned with organizational goals. Before accepting a job offer that includes an EIP, talk to friends, colleagues, co-workers, mentors, or research other forums to get a sense on what the market is offering.

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