Most successful startups have a well-defined employee compensation plan. As a result, they can more easily attract and retain top talent – as well as reward all team members in case of success.
In this guide, we will help you understand all the details of employee comp plans, as well as explore the different equity-based and phantom-equity-based compensation plan types such as ESOP, VSOP, and warrants.
Let’s start with the basics…
What is an employee compensation plan?
The employee compensation plan usually has three parts: salary, bonuses, and equity. The plan itself is a set of directives that define the compensation rules for all teams and employees within the company.
An employee’s comp plan is part of their employment package, along with other benefits and incentives such as company-funded work devices, paid vacation, and healthcare benefits.
By implementing incentive plans early on, startup founders can attract top-tier talent from the start. In the later stages of the company’s lifecycle, the management of employee compensation moves under the CFO or COO, as well as the HR team.
How to create a compensation plan?
Usually, the compensation plan is created in collaboration between the company’s CEO, CFO, and the HR team.
To give your employee compensation plan a solid structure and future-proof it against expansion and high-speed growth, take time to get things right from the start.
Here are the key steps for creating a comp plan:
- Define your compensation culture – the high-level philosophy of how you reward your team members
- Choose what to include in your plan: salary, bonuses, equity, benefits, etc.
- Create a compensation structure based on job roles, locations, and seniority
- Decide how often and by which means the compensation will be paid
- Set up a compensation tracking system, including equity management tools
- Communicate your compensation plan to the management teams, so everyone can make informed decisions
Tip: When setting up the employee compensation strategy, consider the market benchmarks. Do you want to be among the top recruiters?
If you’re limited by resources and can’t (or don’t want to) pay as high salary as the other companies competing for similar talent, aim for higher bonuses and the future potential of equity-based incentives.
Employee incentives: bonuses and equity
Incentives, such as bonuses and equity compensation, are a primary component of advanced compensation plans, serving as motivators to enhance employee performance and boost productivity.
One of the key differences between bonuses and equity is that the bonuses are usually based on the employee’s monthly, quarterly, or annual performance. Depending on the company’s performance, bonuses are subject to frequent change.
For example, a Sales team member could be given a 30% bonus on top of their regular monthly salary each month if they reach X revenue in sales.
What is equity-based compensation?
Equity-based compensation means giving employees an ownership interest in the company.
The equity-based incentives, unlike one-off bonuses, are developed to drive long-term performance.
Read more: Equity vs Salary – which one to choose?
Usually, the new employees are given equity (e.g. in the form of stock option shares, phantom stocks, warrants, etc.) when joining the company. To earn the shares, they will have to work in the startup for up to a multi-year period, during which their stock options get vested.
Advantages of equity-based rewards for employees:
Ownership and investment
Giving employees some equity in the company means that they’ll have a direct stake in the company’s success. This will lead to higher performance, as well as a longer retention period.
Each employee has the potential to accumulate more wealth over the years they spend in the company compared to conventional salary structures.
Investment-savvy employees can look at share options as an asset class alongside their other personal investments.
Tax advantages offered in some countries can result in lower taxation than on regular salaries.
Advantages of equity-based rewards for the company:
Talent attraction and retention
Fast-growing startups can attract top talent interested in the long-term growth potential of the company.
Cash flow management
Early stage startups can improve their cash flow management by offering the long-term earning potential from the company's success to compensate for the lower salaries in the beginning.
Enhanced engagement and performance
Employees who have an ownership stake in the company feel more engaged and invested in its success.
Depending on the chosen equity (or phantom equity) compensation plan, the company may benefit from tax deductions.
If you seek a means to reward your team, simultaneously fostering long-term financial prudence, incorporating equity-based compensation could be the ideal solution for your startup.
Educating employees about equity
Because equity is not visible on the employees’ monthly payslips, it is important to educate your team about their stock options plan and the value of their shares.
Most startups use a stock option management platform to…
- Allocate a % of the shares to each employee
- Track the cliff and vesting period of each employee’s option shares
- Visualise for each employee the current and/or future value of their shares, as well as the vesting period
Equity-based employee compensation plan types
Let’s take a look at the key types of equity-based compensation.
Keep in mind that not all alternatives are available in all countries. Depending on the stock options taxes and other legal restrictions, you will need to choose the type that best fits your company.
Employee incentives can be divided into two main groups: real equity and phantom equity. The benefits of the plan differ for each group. For VSOP and SAR, employees receive cash, while ESOP, warrants, and ESPP offer shares. We will explain each of these in detail.
Type 1: Real equity-based plans
Real equity means the employees can have a direct ownership stake in the company.
In countries with well-developed regulations and practices in the startup ecosystem, plans with real equity are commonly used.
The real-equity-friendly regulations may include tax reliefs or tax deferrals, where the tax point is shifted to later, and may define specific conditions that must be met to qualify for these tax reliefs under the law.
However, real equity can become a challenge as your company expands to additional countries.
Establishing a universal incentive plan based on real equity across different jurisdictions becomes difficult, as it requires adapting to each country's laws and meeting specific conditions for qualification.
Out of real equity plans, the most popular is the ESOP – employee share option plan.
With ESOP, the employees are granted the right to buy company shares over a specific period of time for a particular exercise price (also known as the strike price).
Currently, the friendliest legal treatment of ESOP is in the Baltic states – Latvia, Estonia, and Lithuania. In these countries, share options can be given to employees for free and with a €0 exercise price because of the tax rules that do not tax the benefit from the discount if the required holding period for options is met.
The minimum holding period of options is 12 months in Latvia and 36 months in Lithuania and Estonia. This means the waiting time until the options can be exercised and shares acquired by the employee to qualify for favourable tax treatment under income tax laws. The exercise price can be the nominal value of shares.
Read more about employee incentives.
Another real equity plan used by startups in several countries is the warrant, which does not differ much from the ESOPs.
However, it still adds another layer of complexity by the need to set up the value of the warrant itself. For example, in Sweden, the warrant plans typically require an initial investment by the employee to achieve favourable tax treatment.
Thus, the value of the warrant is needed. The employee might pay the company 5% to 20% of the last round's valuation to buy out the warrants.
Some startups choose to set up their employee compensation plan by using another real equity plan – ESPP, which stands for employee share purchase plan.
With ESPP, the employees can purchase shares for an agreed price after all the applicable vesting requirements have been met. However, usually, there is no favourable tax treatment for ESPP in Europe, and such benefits to employees will be taxed at the vesting date as income from employment.
Some countries provide specific regulations for employee incentive plans for startups or small businesses. For example, in France, there are warrants to subscribe for shares of a business creator known as BSPCE (Bons de souscription de parts de créateurs d’entreprise).
BSPCE gives its beneficiary, under certain conditions, the right to subscribe to a share of the issuing company at a price predefined at the time it is granted (known as the strike price or exercise price).
Type 2: Phantom equity
Compensation plans with phantom equity are mainly used in countries with burdensome or no share option regulations.
Lately, the phantom equity plan is more prevalent for distributed teams as it removes the need to adjust and qualify under various jurisdictions.
Phantom equity types include VSOP (virtual share option plan) and SAR (share appreciation rights), for example.
Under phantom equity plans, the most popular is VSOP – the virtual share option plan.
As its name already provides, the employee, as part of their compensation plan, will not receive actual shares or options but is promised payment in cash if certain future events occur.
Payment under VSOP is considered a bonus payment. However, the plan uses the same logic as actual ESOPs with vesting, cliff periods, and exit events. The payment is calculated on the basis of the value of the company shares.
The benefit of VSOP is the simplicity of adopting and scaling it across different jurisdictions, as cash payments are taxed as income from employment.
Another phantom equity compensation plan is SAR – share appreciation rights.
Similar to the virtual share option plan, the employee with SAR will not receive actual shares but only the value in the form of a cash bonus, which is taxed as income from employment.
The only difference from the VSOP is the terminology used. Everything else remains the same: vesting, cliff, and exit events.
Equity-based employee compensation plan example
Introducing an employee incentive plan can be tricky and raise questions such as:
- Which plan should we choose?
- What rules should be applied?
- Will all employees be treated equally?
- How legally burdensome is it to apply the same plan to all employees across different teams and countries?
To give you some insight, we have created an example use case that gives a feeling of what you should consider.
Single-country equity plans
Time to implement: high
Cost to implement: high
Tax efficiency: ✅
You should research the rules applying to the long-term incentive plans used in each country and local requirements by law, probably in the local language. It might require some filing or notification requirements to local authorities.
If the company wishes to benefit from favourable tax rules for ESOPs, the result might be as follows.
- Minimum holding period of 12 months
- Exercise period of 6 months in case of leaving the company
- Need to notify the State Revenue Service within two months of signing each grant agreement
- Need to submit ESOP details described in the form provided by law requirements
- Minimum holding period of 36 months
- At the moment of exercise, the employee must be employed by the company
- Minimum holding period of 36 months
- Need to report the issuing of options to employees to the Estonian Tax and Customs Board, digitally signed or notarised
- As VSOP has no specific regulation, a general VSOP template can be used to align with all other plans
Where the admin burden to manage four different local requirements is high, the cost to implement plans per each country is also high. However, the result might be four different long-term incentive plans with tax efficiency in 3 out of 4 countries.
Generalised equity plans
Time to implement: low
Cost to implement: low
Tax efficiency: ❌
Generalisation would mean taking one of the countries' local legal requirements and using these for all countries.
However, if the equity plan type used is ESOP, it might raise the risk of taxation at earlier stages if it is not adjusted to the local tax rules.
For example, when following the Latvian ESOP rules, the employees in Lithuania, Estonia and Germany might be at risk of taxation at exercise because they do not qualify under the local tax reliefs.
With VSOP, the cross-border equity granting would be easier, as the benefit of VSOP would be cash bonuses treated as income from employment and taxed accordingly in each country.
The end result might be one long-term incentive plan with no tax efficiency.
PROs & CONs of equity-based compensation plans
Before you decide to make equity part of your employee compensation plan, consider some of the common challenges and benefits that arise.
- Engagement: higher employee interest and retention
- Adaptability: founders can tailor the equity plan to their needs
- Cost efficiency: Equity-based compensation schemes typically demand lower initial expenditure compared to salary and bonuses
- Higher risk: the value of the company's stocks can be unpredictable
- Limited liquidity: the liquidity of company shares can be restricted, making it difficult to turn shares into cash
- Complexity: setting up an equity comp plan requires legal oversight and constant management
- Dilution: as the company issues increasingly more stocks to employees, the ownership percentage of current shareholders may diminish
No matter which employee compensation you choose to set up, remember that it is not set in stone.
Keep your company’s incentives flexible, so that you can remain competitive on the hiring market for top talent, as well as keep the current employees happy with their future prospects.
Need help with setting up a compensation plan or with your stock options management? Get in touch with Salto X’s team of legal and stock option experts.