New businesses frequently offer their first employees equity in the company as a form of compensation. Owning a stake in the business can be a lucrative financial asset for the employee if the company’s stock value increases. Equity compensation can therefore act as an incentive for the employee to invest him- or herself personally in the success of the business. Founders benefit from this arrangement as well: by offering equity to their new hires, they can save cash while, ideally, recruiting top talent.
At the same time, there are legal issues involved with equity compensation, which can make it a double-edged sword. Our attorneys protect the best interests of your business by offering practical advice and sound counsel concerning the benefits and risks of equity compensation.
Five critical steps in offering equity compensation
If the equity compensation model fits best with your new startup, there are a few basic steps you should take to effectuate it:
Step 1: Create an Employee Stock Option Pool (ESOP)
Begin by setting aside approximately 10-15% of your company’s equity for your Employee Stock Option Pool, or ESOP, for your future employees. As you distribute the equity and the pool decreases, you can increase the percentage of equity that is designated for the pool. This will allow enough equity for employees who later join the company. You can do so by diluting the shares of existing shareholders.
Step 2: Select the type of equity you wish to offer
There are three main kinds of equity that startups typically grant to their new employees:
- Stock options. These give workers the right to buy or sell a certain amount of shares from the founders at a preset price. An employee can exercise this right between the vesting date and the expiration date.
- Stock warrants. A stock warrant is the right to buy or sell a set amount of shares from the company (as opposed to the founders) at a predetermined price. Warrants can also only be exercised between the vesting and expiration dates, but they typically have longer expiration dates versus stock options.
- Stock grants. These amount to employee ownership of a specific amount of stock. An employee can immediately sell his or her shares because there is no vesting or expiration date.
Step 3: Choose the vesting period
Where vesting is relevant, your next step is to decide the time period during which an employee must earn (vest) their equity by working for the business. Four-year vesting periods, in which an employee earns ownership of 25% of their stock each year, are common. It’s also standard to have a one-year cliff period, which is the minimum time the worker must stay with the company before vesting begins.
Step 4: Determine how much equity to grant each employee
Various factors can affect how much equity each startup employee will receive. One business may grant equity based on the employee’s seniority, while another might offer equal amounts to all workers. The first employees usually receive more equity than those who join later.
Step 5: Use a capitalization table to document employee equity
A capitalization or cap table is a written record of everyone who is a shareholder of your company, including employees, advisers, and investors. The cap table should detail the total number of stock options already exercised along with the total number of shares that are still available in the option pool. It is imperative that you regularly update this document to ensure it accurately reflects the company’s current ownership.
Legal considerations in offering equity compensation
Offering equity may sound fairly simple, but it can quickly get complicated if the founders don’t do it properly. Here are some potential issues you need to know about:
- A 409A valuation must be conducted by a third-party to determine the fair market value of the equity before it is issued. This ensures employees are being fairly compensated for their work.
- Securities laws govern equity issuance, with some examples being Rule 701, “no sale” requirements, and Section 4(2) or Regulation D.
- Equity compensation has tax consequences, implicating (for instance) income tax and capital gains tax. Taxes can affect the overall value of equity compensation and the nature of the compensation plan.
- Federal and state corporate laws can create significant regulatory issues that companies must know about. Properly issuing equity requires careful planning and thorough understanding of these laws.