This is one way to attract and retain employees to a startup company. Since most companies lack the initial funds to get high quality employees, they use equity compensation to fulfill this need. Equity compensation is a non-cash compensation that represents a form of ownership interest in a company. Due to the complexity of implementing an equity compensation program, companies must plan and use proper legal, accounting, and tax advice and planning.
Companies that offer equity compensations give employees stock options with the right to purchase shares of the companies' stocks at a predetermined price, also referred to as exercise price. This right "vests" with time, so employees gain control of this option after working for the company for a certain period of time. When the option vests, they gain the right to sell or transfer the option. This method encourages employees to stick with the company for a long term.
Employees who have this option are not considered stockholders and therefore do not share the same rights as shareholders. There are different tax consequences to options that are vested versus those that are not, so it is necessary for employees to look into what tax rules apply to their specific situation. There are different types of equity compensations; these include non-qualified stock options and incentive stock options (ISO). ISOs are only available to employees and not non-employee directors or consultants. These options provide special tax advantages. With non-qualified stock options, employers do not have to report when they receive this option or when it becomes exercisable.