Equity compensation
Lesson in Course: Finance at work (beginner, 4min)
We usually get paid with cash. What is equity compensation and how does it benefit me?
What it's about: Understanding the value behind equity compensation and how it's different than a salary.
Why it's important: Certain companies and employers offer equity as part of total compensation.
Key takeaway: Equity makes us joint owners in the company and we share in the success or failure of the business
The payment we receive for our work can take many forms. On the island of Yap in Micronesia, workers are paid in donut-shaped Rai stones for a hard day's work. Meanwhile, employers in the US pay workers in dollars.
However, some employers may include equity compensation in addition to money.
Alternative payment in the form of ownership in a company.
The limits of wages
The salary or wage for any job is based on a pay range determined by what companies are willing to pay for that role. And hopefully, our HR department understands how these ranges fluctuate every year and adjusts our salaries accordingly. We call any job market adjustments to our salary or wage a cost of living adjustment or merit increase.
Getting paid a wage has its limitations. Even though we can be experts at what we do and create a lot of value for the company, our paycheck is tied to specific parameters a business chooses to follow - whether it is compensation bands, tenure, or budgets. Due to that, our compensation isn’t always tied to the value we create for the company.
In most cases, a promotion or a new position with higher pay uncovers a salary or wage increase. However, promotions are limited, but companies want to keep their talent.
Equity is the equalizer
Equity, or ownership in the company, becomes the equalizer. We become owners when companies grant us shares as part of our compensation.
As we work hard and do our job well, we add value to the company. Therefore, for every dollar of value that we create for our company, a portion of that value comes directly back to us for being owners. Companies often have enormous growth potential, which means the value of our equity compensation will grow with it.
When Facebook IPO'ed in 2012, the company's stock became publicly traded. The share's value rose, making over 1,000 employees millionaires overnight. Those employees made a fortune because of their equity compensation, not because of their salaries.
Not all outcomes are favorable. Many startups and even large companies end up failing.
Lehman Brothers was one of the largest investment banks and had been around for 158 years. They rewarded their employees well with equity compensation. The shares had been invaluable until the company collapsed, and the stock price plummeted during the 2007-08 financial crisis. Its 25,000 employees lost their jobs and over $10 billion of wealth.
The upside is that equity compensation could be worth more than the company could have ever paid us in a salary. The downside is that it could be worthless if the company goes out of business.
Actionable ideas
We shouldn't overlook our equity compensation because it could lead to tremendous wealth and be worth more than any salary we'll ever earn. However, we also need to weigh the risks of buying and holding company stock. If something terrible happened to the company, we could lose our job (our income), and our shares would be worth very little or nothing.
What's next
Learn how Java Wealth Planning can help you with your equity compensation.
Glossary
Payment to an employee in the form of ownership in the company.