Anthony points to a good overview on equity-based compensation. Motivation issues aside, such plans are also a key means to attract and keep top talent when you might not otherwise have the means (i.e., an early stage startup).
The article discusses the three primary forms of equity - Incentive Stock Options (ISOs), Non-qualified Options (NQOs), and a stock bonus plan.
ISOs are preferable because of the tax treatment for the recipient, but there are stricter requirements in issuing them. A brief matrix outlining the tax implications of ISOs and NQOs is below.
Event
ISO - Tax to Employee
ISO - Tax to Employer
NQO - Tax to Employee
NQO - Tax to Employer
Grant
None
None
None (if close to FMV)
None
Exercise
None
None
Ordinary Income
None
Sale of Stock
Capital gains above exercise tax
None
Complicated (if held for 2 years, capital gains only)
None
As I briefly discussed with regard to the options scandals, the goal is to postpone and potentially lower the tax to the recipient.