Equity Compensation: Types & How It Works

If your budget doesn’t allow you to hire top talent, equity compensation can. 

Professionals typically prefer bigger checks at larger companies. And as many startup owners can’t offer high, competitive salaries, they may struggle to onboard top talent. But what startups can suggest is an attractive equity package—giving employees a stake in a company and a reason to be a part of something big.

However, this doesn’t mean you should start handing your company’s equity right and left. 

Before taking any equity-related decision, you must first think about:

➡️ Equity dilution (so you don’t give away too much too early);

➡️ The type of equity compensation (to understand which one works better for you and your employees);

➡️ Tax treatment (different types of equity pay are taxed differently);

➡️ How to manage your cap table properly (a messy one can lead to problems while raising funding).

In this article, we’ll talk about what equity compensation is, how your team members can get paid in equity, tips on how to make your cap table work for you while fundraising, and the tax side of stock based compensation.

What is equity compensation, and why should startups care about it?

Equity compensation is a strategic option for companies, especially startups, to pay their employees, executives, and advisors with company ownership instead of (or together with) cash. In such a way, employees can get not only salary but also stock options, RSUs, or other equity grants that give them a stake in a company and its future success.

Many founders love equity-based compensation because it allows them to get top talent on board without draining cash too much. Taking this compensation model also helps startups keep employees in the long run—the better the company performs, the higher the share price, and the more employee benefits (a win-win situation).

Ultimately, you have a cool instrument to retain talent, build a motivated team, and reward performance without spending too much on salaries.

Equity compensation is a great option, but only if you understand how to use this tool correctly. 

❗If you give too much equity too early, you may end up with little ownership for yourself.

✅ Solution—Plan your equity grants carefully and keep an option pool (typically 10-20%) for future employees, advisors, and key hires. In such a way, you may avoid too much equity dilution. Note that you should keep the information on who gets equity, which type, and how it vests in a company’s equity incentive plan.

❗If you give equity without a vesting schedule, employees may still own shares even though they left your company. 

✅ Solution—It’s better to have a 4-year vesting schedule with a 1-year cliff.

❗If you don’t know the difference between NSOs, ISOs, and RSUs, tax bills may surprise you (negatively, of course).

✅ Solution—First, learn yourself and then educate your team on tax-related issues, such as capital gains, ATM, etc.

❗If you don’t properly explain the benefits of each equity compensation type to your employees, they may reject them or misuse them.

✅ Solution—Make sure that your employees understand what they get and how to use this.

❗If you don’t know how to structure your capitalization table (cap table) right, you may scare off VCs (investors analyze your cap table before investing, and they like it to be clear and well-organized).

✅ Solution—You should know how to design your equity plan and cap table in order to make it look good for investors.

What are the types of equity compensation, and how do they work?

Let’s flesh out each type of equity compensation. 

1. Stock options

Stock options are one of the common equity compensation models. When you choose stock options, this means you give your employees the right (note, it’s exactly the right, not the obligation) to buy company shares at a price agreed upon before (aka exercise price). It’s important to mention that employees can exercise their options only after a vesting period. 

💡 A vesting period is the time an employee must wait before they can exercise their stock options. With this type of equity compensation, you don’t give employees full access to their options immediately—the process of vesting helps you make sure these employees will stay with your company long enough to earn them.

The benefit from stock options comes from the difference between the stock’s market price (at the time of exercise) and the exercise price—called the spread. The bigger the spread, the better—the more money employees get when selling shares. However, this also increases the tax burden (later in the text).

There are two types of stock options: 

• NSOs (Non-Qualified Stock Options)—can be given to anyone: employees, contractors, advisors, and other service providers, but with NO tax benefits.

• ISOs (Incentive Stock Options)—can be granted only to employees and have tax benefits.

NSOs are more common in the startup world because they are simpler and easier to manage. Although ISOs offer tax perks to their holders, they have more complex eligibility rules and specific requirements to get the desired tax relief.

🚨 Taxes alert

As for NSOs, employees need to pay taxes two times—when they exercise their options (ordinary income tax) and when they sell their shares (capital gains tax).

As for ISO, if employees follow the rules, they can get tax perks:

• At exercise (no ordinary income tax, but AMT may apply); 

💡 AMT (Alternative Minimum Tax) is a tax that may be triggered by a large spread when exercising ISOs. 

• At sale (may be taxed at long-term capital gains rates, which means lower taxes).

2. Restricted stock

Restricted stock is also a common but less risky type of equity compensation (compared to stock options) because employees typically get company shares for free—they don’t need to buy (exercise) their equity awards. The only thing employees need to do is to meet vesting requirements (similar to stock options—a 4-year vesting period with a 1-year cliff). After this, they start fully owning the shares.

Restricted stock also has two types:

• RSUs (Restricted stock units)—are granted after a vesting period without any purchase.

• RSAs (Restricted stock awards)—are given immediately but with conditions (like a risk of forfeiture if the employee decides to leave the company before RSAs fully vest).

🚨 Taxes alert

Both RSUs and RSAs are taxed when employees vest and sell them.

As for RSUs, employees need to pay ordinary income tax based on the full value of the shares at vesting and capital gains tax if they decide to sell their shares later at a higher price. 

As for RSAs, employees may avoid taxation when vesting if they file an 83(b) election (in this case, they pay tax immediately at the grant price, meaning they pay less money). But they still pay capital gains tax when selling their shares later.  

3. Stock appreciation rights (SARs)

When you grant SARs as equity compensation, you don’t actually give shares to your employees; you let them benefit from a company’s stock price increase—employees get a bonus based on how much the stock price goes up over a set period. 

If the stock price goes up, employees get the difference in value (paid in cash or stock). If the price goes down, employees neither get nor lose anything.

Why are SARs a good equity-based compensation option?

✅ Employees don’t need to buy stock, meaning there’s less financial risk. 

✅ There’s no equity dilution—since shares aren’t issued, the ownership isn’t affected.

✅ SARs give flexible payout options—either in cash or shares.

🚨 Taxes alert

SARs are taxed as ordinary income when employees exercise them (NOT when SARs are granted or vested).

4. Employee stock purchase plans (ESPPs)

With this equity compensation model, employees can buy stock in their companies at a discount—usually 5-15% from the FMV (fair market value)—using money which will be deducted from their paycheck over time. 

To elaborate, employees choose to set aside some part of their salary to purchase stock. At the end of a set period, the company buys stock for them (at a discount), and now the employees own shares and can either keep or sell them for profit.

🚨 Taxes alert

Here, everything depends on whether employees hold the shares long enough to get favorable tax treatment. 

If they sell ESPPs too soon (before two years from the grant or one year from purchase), they’ll pay ordinary income and capital gains taxes. 

If they meet the holding period, they’ll pay ordinary income tax at a lower amount and long-term capital gains tax, which has a lower tax rate. 

5. Performance shares

Performance shares are one of the forms of financial compensation linked to employee performance. Employees may be given them only if certain company goals are met—like hitting a revenue target or stock price milestone. These equity awards are typically given to executives and directors to incentivize them to achieve particular business goals.

🚨 Taxes alert

Here, employees pay ordinary income tax when they vest shares and capital gains tax on the spread when they sell shares.

What’s the connection between equity compensation and fundraising?

Direct. 

Of course, the way you decide how to pay your employees alone isn’t a 100% deal-breaker. But if your equity compensation is poorly managed, it can raise some red flags for investors. 

Investors check how well you can structure equity grants, deal with dilution, and plan for the future. If you can’t make a clear cap table, maybe you won’t be able to grow and scale your company—that’s what they may think. 

A messy cap table means (99.9%) that your valuation will suffer. Your pre-money valuation is about how many shares have already been issued. If you’ve given away too much equity in a company too soon, this means each share has less value, which, in turn, can lower the amount of capital you can raise. 

If you are wondering what equity details you should show to investors, here’s a short list:

• A clear cap table;

• A breakdown of vested and unvested shares;

• Details on stock options;

• Convertible securities, like SAFEs or convertible notes (if you have any).

Remember, every funding round dilutes existing ownership; that’s why it’s so important to plan everything ahead. You should know very well how pre- and post-money valuation works, which rights you, investors, and other shareholders have, and how to adjust your option pool and cap table. 

Wrap-up on equity compensation 

As a startup owner, you may use a mix of salary and stock-based pay to onboard talent. Some common compensation examples are profit-sharing, equity grants, and performance-based bonuses. And it’s on you to decide which one to choose or how to structure your team’s compensation model. 

Just in case of equity compensation, make sure you understand what it means and how it works, know everything about taxes, have a clear equity plan, and can communicate this all to your employees so they also have a full grasp of what they get and how they can use it. 

Remember that your stock-based compensation isn’t only about getting new employees; it’s also about your fundraising efforts—investors look at your cap table, ownership structure, and equity incentive plans.

What else they look at is your business plan, financial model, and pitch deck. Thus, when rushing to structure your equity compensation, don’t forget about other nitty-gritty stuff. 

Seek help creating investment documents that VCs will love or need assistance while fundraising? Contact our Waveup team. Our experts have years of experience in venture capital, finance, and business growth, so they know how to help you close your funding round successfully.