What's it worth? Valuation of equity compensation in privately owned companies
Overview of equity compensation plans
An equity compensation plan is any program designed to provide participants with income tied to the value of ownership in the company where they work. Participants in an equity plan can be employees, directors, or contractors who provide services to the company. A plan can be broad based — encompassing a large number of or all employees — or it can be narrow, including only a few employees such as key management.
Compensation awarded in an equity plan can come in a variety of forms. These include stock options, restricted shares, restricted stock units, stock appreciation rights, stock purchase plans, phantom shares, or other instruments tied to the equity value of the company. The most common types of equity compensation are further described in this paper. The range of alternatives in the types of equity compensation provides flexibility in the design of a plan to accomplish a variety of objectives.
Equity compensation is provided in addition to wages, salary, bonus, profit sharing and other forms of compensation. However, equity compensation has some important differences when compared to other types of compensation. First, the award of equity compensation is a non-cash form of payment to the recipient. Participants receive an equity interest, not cash. Second, the payout on equity compensation is deferred, with the recipient receiving payment at a time, often years, in the future. Finally, equity compensation is not a fixed payment amount; its value can change over time.
Equity compensation has a number of characteristics that distinguish it from ordinary shares of stock in the company. Compensation granted as equity is for services provided to the company, usually without any cash payment from the recipient. This is in contrast to where regular shareholders will have provided actual payment or other consideration for their shares. Equity compensation can be subject to restrictions, whereas regular shareholders have full rights and value in their shares. Finally, equity compensation can have a risk of forfeiture or might never be cashed in, while regular shareholders have an established and ongoing right to the value of their shares.