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Equity Compensation: An Effective Retention Tool?

How can we transform standard equity compensation in venture into a more effective retention and overall benefits tool.

What types of companies give employees stock awards?

There are various factors that attract individuals to work at any given company. Believing in the product, mission, or culture of the company are just a few of these factors, though compensation remains one of the most decisive ones. Especially for talented individuals, job opportunities can be ample with each opportunity offering a varying combination of these factors.

Startups are often not able to offer salaries that are as high as what other, more established companies, can offer. And so, they add other factors that they think are attractive to the total compensation mix, such as flexible benefits and more importantly, stock awards (equity ownership).

Stock awards, in particular, are a very powerful tool that allows companies to attract individuals who believe in the long-term potential of the business. In addition to helping make an employee’s overall compensation package more attractive, giving employees stock aligns incentives toward the company’s future growth and success. 

How are employee stock awards issued?

Companies often offer employees stock awards in the form of a contract, as part of an overall compensation package. Stock awards usually come with predefined conditions though, to avoid people from joining startups just to make a quick gain and then leave.

A commonly enforced restriction is time spent with the company. Effectively, startups would reward employees with stock in exchange for pre-defined tenures of employment. For example, the company may require a period of time (referred to as a ‘cliff’) that employees need to spend with the company before they become eligible to own stock. And then, the amount of stock promised at the time of hiring is issued over a predefined period of time (a ‘vesting’ period) at pre-set frequencies or dates (a ‘vesting’ schedule). The cliff and vesting period associated with equity compensation plans (often structured as a 1-year cliff with a total 4-year vesting period) help with talent retention; meaning, they aim to encourage talent to stay within the company and commit to its long-term growth as shareholders. 

While there are several forms of stock awards, two popular types include stock options and restricted stock units:

1. Stock options: Employees can be granted the option to buy a set amount of company stock at a particular point in the future. This purchase would be at a predetermined price (‘strike’ price), regardless of the actual market value of the stock at that point in the future. Employees who accept stock options anticipate that the stock would be worth more in the future than the predetermined purchase price (‘strike’ price). The strike price can set as zero, or have a specific value at the time of granting, depending on the company's stock option plan.

In the future, employees hope to make a financial gain by selling the stock that they acquired, allowing them to lock in financial returns, which can be considered as part of their company’s compensation.

2. Restricted stock units: Employees can be granted company shares as compensation for their employment, without requiring them to buy the stock from the company. RSUs usually come with a set of conditions such as vesting period and transfer restrictions.

As with stock options, employees hope to make financial gains from restricted stock units by selling them for financial gains. The main difference being that they are not tied to a certain strike price, with the value being determined at the vesting dates.

Can employees actually sell their stock awards?

Employees can technically sell their equity at certain points in time, conditional on company approval and depending on the type of equity compensation plan - however, this process can be cumbersome and riddled with administrative hurdles. In practice, liquidity therefore typically becomes available to employees once the company has experienced an exit event (e.g. IPO or company acquisition), whereby employees sell their equity to the open market or to a specific acquirer. So until the startup has gone through some form of exit event, the equity owners — including employees — do not tend to readily have a market to sell their stock awards, making this asset illiquid.

Some companies run equity buyback programs with employees where they offer to buy back the stock awards that they’ve issued to them, at a particular price, as a means of providing liquidity to them prior to an exit. These are typically one-off programs and therefore not a consistent liquidity option for employees. Some may even argue that buybacks are not the best use of an early-stage company’s capital when they can instead be used to fund growth.

Being traditionally illiquid, however, doesn’t make stock award programs “bad” in any sense, in fact, illiquidity has been built into these programs by design, and, as such, has not been considered a tangible go-to cash option for employees should they need to suddenly access some liquidity — for example: to fund unexpected life events.

What benefits can come from providing stock award liquidity?

The initial intuition (and in line with a lot of the reasoning referred to in the previous sections) would tell you the more the equity an employee (or founder) has tied to the company, the more motivated and committed he or she will be to its long-term success.

There are many arguments that support this statement, and a lot of them are undoubtedly true. Owning a share of what you’re building, having skin in the game - or any other way you may say it - definitely does bring a different level of engagement and commitment to a company. Like anything in life, ownership brings with it a deeper sense of responsibility and accountability. 

The question is however, what is the right balance between equity (or ownership) and a cash salary, benefits and other tangible matters that affect an individual’s day to day life? 

To attempt to answer this, we could deep dive into human psychology, behavioral economics, or other well researched scientific theories that analyzed related topics. The conclusion will be however, that there is no single correct answer that holds true across all individuals.

If you take a step back, this non-definitive conclusion tells you a lot already. 

It tells you that every individual is different. It tells you that circumstances may change, with motivations and needs constantly adapting to a situation. That being said however, there are certain truths (or a standard) from which you can build your thinking, adapting and innovating to target a wider range of individuals to respond positively to a company’s overall compensation strategies.

Providing controlled liquidity and allowing employees to supplement their income (if needed) is very likely to improve engagement and empower them as true stakeholders - creating a positive effect on their day-to-day and overall company performance.

This is especially relevant in times of economic uncertainty, rising inflation and liquidity constraints.

Recent examples in the media of companies that offer this perk include Carta and Cruise. And we are seeing more and more companies adopt this over time.

What is controlled liquidity and where does Zest come in?

Too much liquidity as another extreme will work in the exact opposite way. Short-term gain versus engagement and long-term commitment. When we talk about liquidity, it has to come over time (similar to how equity vests over time) and accessed when and if needed during company set liquidity windows. 

Zest works closely with companies to develop, launch and manage controlled ‘liquidity as a benefit’ programs tailored to their specific needs. The idea is for these programs to be built into an employee’s compensation / benefits plan – with small percentages (2,3…5% of vested equity) to be tradable over time as long as they are actively employed and performing. This relieves the pressure on the company to increase the ‘cash’ portion of employee compensation as well. 

Zest’s platform enables liquidity through a wider investor base, removing any pressure on the company to use its own cash to fund these programs. And in parallel, allow a wider range of investors to be part of their growth story with limited disruption and interference.

 

If you want to pioneer change and build employee commitment, reach out to Zest.

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