Dreaming of getting rich? To increase your chances of that dream coming true, you may want to consider equity compensation rather than focusing entirely on earning a higher salary. Think about the billionaires in the world. How did they make their wealth? Almost all of them got their high net worth from equity stakes in businesses that grew into successful companies.
But with the potential reward comes significant risk. Which is better for you, equity compensation or a higher salary?
Why consider equity compensation?
Equity compensation is especially common in startup firms and relatively young companies, each known for needing to preserve cash. Often, they’ll offer equity compensation in return for giving you a below-market salary. With you having a stake in the company, your potential earnings are virtually limitless.
Even the professions that earn the highest-salary. Such as investment bankers, hedge fund managers, doctors, and prominent lawyers. They don’t crush it with their six-figure salaries until they become partners in their respective firms or practices. When you become a partner, that’s when you tap into the magic of equity.
Owning equity means you’re essentially part-owner. And when you’re an owner, your success grows as the company grows. If it’s a business that climbs to the top of its market, your options for wealth building skyrocket and your dream of getting rich becomes a reality.
If you find yourself weighing an equity compensation possibility, here are three points to consider.
1. It isn’t the same as money in the bank
With your success directly tied to the success of the company, there’s no guarantee that you’ll gain from your equity. When you get a salary, you know exactly how much you’re getting. It’s a fixed sum that you can count on and use to plan your future. However, there are too many variables that influence whether your equity stake will pay off.
The first variable is that the startup will have to succeed for your stake to pay off. Since more than 50 percent of small businesses fail in the first four years, you could end up high and dry. Equity compensation isn’t the same as money in the bank.
2. You may find yourself tied to the company
Changing employers, or even career fields, is common. According to data collected by the United States Department of Labor, people shift employers between ten to fifteen times during their lifetime. If part of your compensation is in the form of equity; it’s critical you know the vesting schedule and rules surrounding your potential payoff. In fact, you may lose your stake entirely if you take a new job.
Equity compensation typically has a vesting schedule, meaning you won’t own your equity until a period of time has passed. Whether you’re considering leaving your employer due to a new job, layoff, or retirement, you need to know what that schedule is. For example, if you’re offered a “four-year vest.” Your equity is given over a period of four years. If you get fired or leave a day before that period is up. You’ll end up with nothing.
3. Consider tax implications
Understanding the structure of your equity compensation could lead to a bigger payout. However, it can also calculate to a lesser amount after you pay taxes. The Internal Revenue Code does allow for limited amounts of qualified stock options. These options are eligible for special tax treatment under certain conditions. However, if the value increases substantially over the fair market value at the grant date, you could be taxed at capital gains rates which increases your tax liability.
Equity payments are structured in a variety of ways. These can include nonqualified and incentive stock options, restricted stock units, stock appreciation rights, performance shares and units, and dividend equivalent units. Each has different tax considerations at the federal and state level. Each of these can be cumbersome and costly if the tax consequences aren’t adequately addressed.
Either way, there are no guarantees
Choosing between cash salary and equity compensation is a personal decision that should be based on your individual cash flow needs. A lower wage could leave you living paycheck-to-paycheck and hurt your quality of life. Ownership is one of the best ways to create wealth and equity compensation gives you the ability to generate more value over time.
Since being paid a salary leaves no potential for a big payout in the future. Sometimes the lure of a higher earning potential is enough to quantify taking on more risk with equity compensation. With the help of your financial advisor, you can determine which option is right for you.