Equity Awards – Everything You Need to Know
An equity award is a non-cash compensation paid in terms of company equity.
Equity awards are the most convenient and trending currency used to design compensation packages in the startup world. Despite its tricky applications, granting equity in exchange for services to the business seems to mutually work for the company as well as the grantee. However, one must be careful about the legal implications, tax consequences, and the accounting treatment of every equity scheme before finalizing one. Else, both the company and the recipient may find themselves paying hefty sums in legal fees and tax fines.
The standard method of compensating employees for their hard work is cash-based salary and incentives. There is no greater motivation than a secured salary. But cash-based compensation is a regular expense for the company and adds to the financial liabilities. This may be acceptable in the case of an established business with a reliable cash flow, but for startups, a regular cash expense in employee compensation truly is a financial burden, hence the need for equity awards.
What is an Equity Award?
An equity award is a non-cash compensation paid in terms of company equity. This is mostly granted in addition to a basic below-market salary in cash. It is a great recruitment and retention tool for early-stage startups that need the best manpower yet struggle with sufficient funding backup to afford them. Offering equity is the only way by which these businesses can compete with high-end compensation offered by a large corporation.
The idea behind choosing an equity award for compensation lies in the time a business gets before the actual value needs to be paid. This concept works only if the company share value accelerates over the years. Thus a company must not entice recipients (employees, advisors, consultants, directors) with equity offers unless the business plans to invite venture funding and possibly approach a plan for sale or an IPO. Getting a 409a valuation is mandatory to determine fair market value while designing equity award schemes.
For example, Joe joins Company ABC as a product specialist. Along with a base salary, he is granted rights to purchase 10,000 shares of the company at $0.05 provided he stays at least for four years and meets all performance standards. Let’s say, the business demonstrates phenomenal growth and four years later the equity value becomes $2 per share. In this case, this is how Joe profits:
Equity value on grant date: 10,000 shares x $0.05 = $500
Equity value 4 years later on maturity date: 10,000 shares x $2 = $20,000
Joe’s profit: $20,000 – $500 = $19,500
Thus with equity awards, the startup did not have to pay hefty cash to hire Joe, yet Joe’s hard work was well rewarded eventually. But this was a simple example. Awarding equity is a much more complicated process and subject to various IRS regulations. Besides, equity to employees is granted by diluting founder shares. Then why should a company choose to grant equity?
Why use Equity awards in your company?
The different types of equity awards are granted from the option pool created by share contributions from company founders. There is no prescription for exact pool size, but it ranges between 10 – 25% of the total company equity. It is better to start small and expand as per business needs. Besides, investors insist on an option pool refresh at every funding round. Investors will never dilute their shares and will demand an option pool shuffle pre-money. Despite consecutive dilution, granting equity awards is beneficial because:
- Offering equity is a useful recruitment and retention tool. It helps conserve cash needed for employee compensations and frees up financial resources to invest in other business development avenues.
- Equity awards are never granted immediately. Every grant is accompanied by a vesting schedule that ensures that employees remain in the company for a certain time before becoming eligible to own stock. This minimizes the rate of employee turnover.
- Equity schemes add value only if the share value appreciates over time. Thus the employee finds sync between their hard work and expanding business profits. This way the different types of equity awards align the employee’s financial interests with that of the business.
- Startup recruitment is a highly competitive space. The negotiations generally come down to equity percentages rather than the value of the entire compensation. A well-designed equity awards system helps attract the best talent in the industry and keep them invested in the business for a long time.
Types of Equity Awards
All types of equity awards in some form or the other grants an employee the option to buy stock, not the stock as it is. Very few schemes may grant the stock directly, but all include vesting schedules. All equity schemes are legal grants and have varying tax implications. Here are some of the common equity grants:
Stock Options (ISO & NSO)
As the name suggests, this type of equity award grants recipients the ‘option’ to buy company stocks at a predetermined price, at a later date. 409a valuations are a must before granting these options, as only a professional valuation can determine the fair market value of the stock. On the grant date, employees are granted the ‘option’ to buy a set number of stock after completion of the vesting period.
Post vesting, if the share price is higher than their grant price, the employee can choose to exercise their options, or else lose them. The idea is that share prices would have shot up by then and employees gain from the differential pricing of the fair market value on the grant date and the actual market price on the exercise date. Stock options are of two types:
- Incentive stock options (ISO): Granted only to employees. Taxed as per capital gains rate and not the regular high-income tax rate.
- Non-qualified stock options (NSO): Can be granted to anyone. Taxed as per regular income tax rates but not bound by regulations applicable for ISOs. NSOs provides greater flexibility.
Stock Appreciation Rights (SARs)
This type of equity award is granted in cash. The recipient is neither granted actual stocks nor the right to buy stocks. Instead, SARs grant a cash value equivalent of a certain number of shares. They are generally issued along with stock options and called tandem SARs. They are always subject to vesting. SARs helps purchase the stock options as well as settle any outstanding taxes incurred in the process. It is quite a flexible tool and can be used in many different ways to create a lucrative compensation package.
Restricted Stock Units (RSU)
RSUs are one of those equity awards that grant the recipient stock in a lump sum, but are subject to vesting schedules. However, restrictions are imposed on the transfer and resale of these stocks until the vesting date. Neither are they granted voting rights until all stocks are fully vested. RSUs are issued to top-ranking executives as their perceived value is much higher than stock options that require to be purchased. These are taxed at ordinary income tax rates only after vesting.
Restricted Stock Awards (RSA)
RSAs on the other hand work in similar ways to RSUs, but the recipient has voting rights from the grant date. Though all stock will be awarded post vesting, this does not prevent them from shareholder privileges. This type of equity award is normally granted to the first five employees of a startup when stakes are high and experienced business heads have to be recruited to form the leadership team. However, vesting schedules are applied to avoid a hit and run case. RSAs allow maximized capital gains and are subject to taxes on the grant date.
Other stock-based awards
Apart from these four stock-based awards, there are two other schemes used in special cases:
- Stock purchase plan: This is a popular equity awards plan among startups with a recent IPO. In this, employees are granted the right to purchase stocks through payroll deductions at a 15% tax-free discount. This is a good method to keep the employees connected with the company’s growth after a heavy liquidity event.
- Phantom stocks: This type of equity award is reserved for top executives where the company promises the value and rights of a shareholder without granting actual shares. They are paid in cash and without further share dilution while still compensating the executive for their efforts. Phantom stocks differ from SARs in the fact that SARs are subject to stock appreciation, but phantom stocks promise a considerable value irrespective of the status of the stock value. They are taxed as ordinary income.
Every equity award is subject to vesting schedules. Vesting acts as a safety net in the case of granting company shares to employees. Besides it is a legal requirement while granting stocks. Let’s see how:
What is a vesting schedule?
A vesting schedule is a timeline for granting stock ownership or the right to purchase stock. It is generally decided by the founders and contractually binding. Most vesting schedules for equity awards include a ‘cliff’ period, which is the qualifying time after which the recipient becomes eligible for stock vesting. A typical vesting schedule spans 4 to 6 years with a one year cliff. If the employee quits before completion of these timelines, they stand to lose rights over their granted stock.
Types of vesting
Vesting schedules are designed based on certain conditions. One schedule does not suit all. On one hand, these schedules must work in favor of the financial situation of the company, while on the other hand, it must align with the employee’s needs as well. There are three commonly used vesting schedules for equity awards:
- Immediate vesting: There is no ‘cliff’ in this case. Usually, senior professionals are hired on immediate vesting terms. They might be granted a considerable chunk of company shares as a joining bonus or as an incentive for a heavy performance target.
- Graded vesting: This is the most commonly used vesting schedule for equity awards granted to employees. After the one-year cliff, stocks start vesting in equal monthly increments throughout the vesting period of 4 years eventually reaching the 100% mark.
- Cliff vesting: In this vesting schedule, equity awards are granted in one go but after completion of the cliff period. This scheme is usually extended to short-term service providers such as advisors, consultants, or strategic directors on the board.
Which Equity Award is best for you?
We have discussed the different types of equity awards and the varying vesting schedules that govern them. But how does one decide which one is the best? There is no set rule of thumb, as all companies are different.
Based on the stage of business and the recruitment timing, companies must design equity awards sensibly for a mutually beneficial deal. Here are some common equity awards and their utility:
- Restricted stock awards: Mostly granted to company founders in the initial startup phase. They are not required to purchase stocks at any point in time, but have to complete vesting requirements before exercising their shares.
- Stock options: Mostly granted to employees and rides on the possibility of accelerating share values. Incentive stock options provide tax breaks while non-qualified stock options can be extended beyond employees, but incur regular income tax.
- Restricted stock units: These are granted in the later stages of the business and never in the initial ones. Employees must be able to fund the taxes incurred from RSUs. These are generally granted by mature companies when the fair market value of the common stock is too high for the employee’s pocket.
Issuing Equity Awards on Eqvista
With the outline of what an equity award is, how they work, and the different types, it’s time now to put your plans into action and set up an organized vesting schedule for your equity awards. And all of this can be done right on the Eqvista platform.
Once you have chosen the type of equity award to use, log into your Eqvista account and follow these steps.
Setup Equity Award Class
The first step to do is set up the Equity Award class you plan to use. In this case we created a new Employee Stock Option class consisting of 100,000 options to use in the future.
Once the Option class has been set up, you can start issuing your first grants to your employees.
In the Option class screen, go to the top right-hand corner and click on “Issue” for new grants.
Once on the next screen, following the steps and include the necessary information to process the new option grant.
Here we made a new option grant of 15,000 options to Sam Anderson on 01 May 2019. Once you click on Submit, the grant will be added to the option class.
Setup Vesting Schedule and Apply to Grants
Now that you have all the options granted for your equity awards, it’s time to create and apply the vesting schedules.
You can do this by going to the left-hand side menu, and click on “Vesting and Plans” under the “Cap Table” category. After clicking on “Create Vesting Plan”, you can set up a new customized vesting plan for your company.
Here we created a 4 year vesting plan with a 1 year cliff, which vests quarterly after the first year.
And after the vesting schedule is made, you can apply it to the share grant directly, and the vesting calculations will be shown in the app right from the grants.
In this case 4,375 of the 10,000 options have vested from the vesting start date on December 31st, 2018 up to now.
And with these three basic steps, you can see how easy it is to create and manage your equity award program on the Eqvista App.
Granting equity awards is a nuanced process and involves various legal implications. Besides, transparency between the issuing company and the stakeholder is crucial for the smooth working of this reward system. Traditionally equity distribution is maintained on a simple cap table on an excel sheet. But as the company grows and equity transactions become complex involving multiple employees and investors, it is better to automate the process.
Eqvista is one of the market leaders in providing equity management software. Eqvista can handle all equity-related activities right from company valuations to issuance of stock certificates on one platform. Here is the range of activities we support. To discuss further, reach us today.