Why Offer Equity Benefits for Employees?
We will explore the motivations behind offering equity compensation for employees and the various ways to go about it.
One of the best strategies to recruit, incentivize, and retain talent in a company is to offer equity for employees. Be it a startup or an established corporate, it is seen that granting equity to employees increases their involvement in the business and has a positive impact on their overall performance. Equity compensation packages have almost become a norm in the startup industry
In this article, we explore this aspect. We discuss the motivations behind offering equity compensation for employees and the various ways to go about it.
Equity Compensation for Employees
Once an employee is hired, the cost of retaining them in the company becomes a recurring expense. But with a fixed salary package the company can also easily budget for these fixed expenses. Then why offer an employee equity program? Considering equity value fluctuates based on market forces and gives away a share of ownership, why should a company choose to introduce equity compensation to employees? Let’s take a look.
Why offer equity to employees?
In a startup scenario, once the company is incorporated, one of the first things founders do is to distribute equity among themselves. This is the starting point of equity distribution. Then as new hires are brought on board, their salary structures include a good mix of the cash and equity components diluted from the founder’s share. As the business grows and more resources are recruited and some premature exits, an employee options pool is created to re-distribute equity thereafter.
Mature companies can afford lucrative cash compensations to hire the best talent in the industry. Startups cannot. Hence startups use equity as a currency to bridge the gap. This is because a startup invariably struggles with a smooth flow of cash in the initial stages of their operations. Yet this is also the time when they need the best talent on board to build and grow the business. The obvious solution here is to offer equity benefits for employees.
An employee equity program is invariably accompanied by vesting schedules. Vesting schedules act as the safety net by which equity is granted based on set conditions. We will discuss vesting schedules in detail in the next sections. However, at this point, it is good to note that offering equity compensation packages with underlying conditions such as time served in the company, performance milestones, etc. acts as a good incentive scheme as well. Apart from startups, this form of incentive works well in big companies where employees chase massive targets and to be rewarded in company equity entitles them to big profits and ownership in the business.
Types of Equity compensation
Equity by definition is a share in the company. But not all shares are the same. Based on ownership rights and tax implications, they are classified into two broad categories: Common stock and Preferred stock. Common stocks are frequently granted and are usually reserved for employees while preferred stocks are for investors. They are:
- Common stocks – Equity compensation for employees and founders are granted as common stocks. Only common shareholders have the right to vote in corporate matters. One share equals one vote. However, in the hierarchy of receiving company profits, common shareholders are last in line. Investors, creditors, bondholders, and preferred shareholders are prioritized in these situations. Common stockholders may not receive regular dividends as is the case for preferred stockholders. But these shares are profitable in the long run.
- Preferred stocks – As mentioned earlier, this category of stocks are reserved for investors. They are entitled to receive regular dividends and rank higher in order of receiving company assets in case of an IPO or liquidation. Unlike common stocks, preferred stocks are issued the ‘call-ability’ feature where the company or the issuer reserves the right to call back these shares from the market after a certain time. On the contrary, the owner also reserves the right to either keep their shares or take back their investments. Preferred stockholders do not have voting rights.
Offering Equity to Employees
Company equity is a pie. When imagining equity distribution, one must keep in mind that with every investment round, equity will be diluted. Companies must reserve equity for funding rounds. Meanwhile recruiting and retaining the best talent is also important for a business and equity plays an important role there. This means that equity benefits for employees must be planned in a way that does not interfere either with recruitment or with investor equity for consecutive funding rounds. So how does one go about it?
How do you offer equity to employees?
Irrespective of the hierarchy, every recruit is a company employee. However, some are placed in more responsible positions of strategic decision making required to drive the business, while others are spokes of a wheel. An employee equity program must consider everyone’s needs and ensure the company’s interests align with the employees as well. But, offering equity is easier said than done.
To issue, track, and manage employee equity and the regulatory documentation that it entails is a cumbersome task which a company should not sign-up for unless ready. Once ready, common stocks are granted to employees in the following 4 ways:
- Stock options – This is the most common method to offer equity for employees. Employees are granted the right to buy stocks at the time of issue, not the stock itself. The price at which the right to stocks is granted is called the ‘strike price’ ‘grant price’, or ‘exercise price’. Over the years as the company grows, stock prices increase as well. Once vested, employees are allowed to buy all stocks at the strike price which by then is much lower than the market price. When employees sell these stocks, they profit from the differential pricing.
- Restricted stock awards (RSA) – As the name suggests, this category of equity benefits for employees is offered to top executives. These resources are usually hired in the early stages of a business to set in motion the best decision-making process possible. They are top professionals with years of experience in the business and will demand the best incentives to join a new company. Restricted stock awards come in handy here. They are usually one-time grants and the executive receives full ownership of stocks from the date of issue. However, restrictions are placed on the sale of these stocks. The last thing a company needs is a hit and run case with their company stocks. The issuer generally reserves the right to buy back restricted stock awards at the issuing price before it is offered to a third party.
- Restricted stock units (RSU) – These work similar to restricted stock awards except that vesting periods are imposed. This type of equity benefit for employees will grant ownership of all stocks all at once but only after completion of the vesting period. This acts as a good incentive scheme and encourages the prolonged association of an employee with the business. The employee also benefits from receiving a lump sum instead of a large amount. Compared to other forms of stocks, restricted stock units have tax benefits as well.
- Founder stocks – This section of the employee equity program is reserved for company founders. Once a company is formed, one of the first things founders agree on in their share in company equity. This is a sensitive process and must be treated with utmost elegance as founders are the foundation of a business and sufficiently rewarding them is important. Most often the reason founders end up in court is due to disagreements about their equity share.
Apart from these four, there are many sub-categories to equity compensation for employees based on variables such as performance milestones, period, and nature of engagement with the company, etc. However, the next question is, how does one calculate the exact value of equity to be offered to employees?
How much equity should I offer to employees?
Assigning equity is not a random act. Over the years certain mechanisms have evolved that helps companies to ensure the best possible equity compensation is offered to deserving contributors. Here are the four basic steps to approach equity compensation for employees:
- Company valuation – The first step towards designing an employee equity program is to get the company evaluated. Irrespective of the stage of company growth, it is advised to engage professional evaluators to arrive at the best company valuation. Only based on this value, equity value can be determined, and hence the value of equity compensation for employees.
- Employee categorization – The next step is to segregate employees based on their roles and responsibility in the business. For example, the top brass executives could be grouped as ‘C-executives’, followed by the directors and those managers handling business units. Engineers, product developers, marketing professionals could come next followed by those employees who handle support functions.
- Multiplier – Once the employee categories are decided, a multiplier is assigned to each of the categories with Class A being the top brass. The multipliers commonly used in practice are:
- x 0.5 – Class A
- x 0.25 – Class B
- x 0.1 – Class C
- x 0.05 – Class D
- Base salary & multiplier – The final step in equity compensation for employees using this process is to multiply the base salary of an employee by the multiplier assigned to their category of employment. This final value is the equity that a particular employee is entitled to.
Now that we know how to calculate equity compensation for employees, we have to understand that it is not advisable to grant the entire sum at a time. It is risky to place all bets at a time on one employee. Both the employer and the recruit must spend time understanding their deliverables before committing to equity.
Vesting schedule for employees
Vesting is implemented using a ‘vesting schedule’. This is essentially a timeline that determines equity eligibility for employees. As observed earlier, we know that not all employees can be granted equity in the same way. Recruits have to be tested for their performance and loyalty towards the company while high-powered executives deserve immediate rewards for their wealth of expertise and contributions to the business. Thus every employee equity program broadly uses three types of vesting schedules:
- Immediate vesting – As the name suggests, stock ownership is granted immediately at the time of issue. This is usually reserved for top executives and is a lucrative form of sign-up bonus. These executives are usually reputed professionals with years of industry experience and are known to honor their commitments. The risk factor of granting equity in bulk is quite low in these cases.
- Cliff vesting – This involves a ‘cliff’ period which is essentially a waiting period an employee has to serve before they become eligible for stock ownership. It is usually the first year of an employee’s service. If they leave any time before the completion of this cliff period, they stand to lose all stocks. However, on completion of the cliff, all stocks are granted immediately. This is commonly used in the case of advisors and consultants on a contract. Cliff vesting is also useful as an incentive scheme.
- Graded Vesting – This form of equity benefits for employees includes a cliff as well as a staggered granting of stocks. For eg. If an employee is granted 1,000 shares over a graded vesting schedule of 4 years with a one year cliff, at the end of one year they will receive rights over 250 shares, 500 shares at the end of the second year, and so on till the fourth year when all 1,000 shares are vested. If an employee chooses to leave in the second year, they will exit with only 500 shares and forfeit the remaining 500. This is the most commonly used vesting schedule and a good strategy to keep employees motivated and invested in the company.
Let’s take another example to explain the benefits of a vesting schedule further. Let’s say an employee Amy Brown was working in a new startup and offered a 4 year graded vesting schedule, with a 1 year cliff, and vesting quarterly thereafter for 5,000 shares. If the vesting for these shares started on July 1st, 2020, the total vesting schedule would look like:
|Vesting Start Date||Shares||Percentage|
|July 1st, 2020||1,250||25%|
|July 1st, 2021||312.50||6.25%|
|Oct. 1st, 2021||312.50||6.25%|
|Jan. 1st, 2022||312.50||6.25%|
|Apr. 1st, 2022||312.50||6.25%|
|July 1st, 2022||312.50||6.25%|
|Oct. 1st, 2022||312.50||6.25%|
|Jan. 1st, 2023||312.50||6.25%|
|Apr. 1st, 2023||312.50||6.25%|
|July 1st, 2023||312.50||6.25%|
|Oct. 1st, 2023||312.50||6.25%|
|Jan. 1st, 2024||312.50||6.25%|
|Apr. 1st, 2024||312.50||6.25%|
Amy Brown’s would have 1,250 shares by July 1st, 2021, equal to 25% of the total amount of shares, and vest 312.50 shares quarterly until 2024. Then after July 1st, 2024 all 5,000 of her shares would be completely vested, and she would be able to sell them or retain them for later if she chooses to stay in the company.
Benefits of Offering Equity to Employees
Equity is a strong currency to recruit top-notch talent and make them feel involved in the business in comparison to being treated like a means to an end. Especially in the case of cash-strapped startups, equity benefits for employees aid to create a holistic compensation package for recruits that equal mature companies.
If the business performs well, over the years the equity component will prove to be far more profitable than regular salary in cash. Here is a consolidated list of benefits of offering equity to employees:
- Equity is a lucrative recruitment tool to attract and retain high powered professionals
- Equity in a company eventually becomes highly profitable in the long run
- The company can conserve cash by reducing the cash component in the employee compensation package and substituting sufficiently with equity
- Employee’s financial goals are aligned with that of the company. Employees can see the results of their contribution directly as the company grow in a profitable trajectory
- An employee equity program with carefully designed vesting schedules reduces employee turnover. Be it regular compensation, performance bonus, or retirement benefits, employees find it profitable to stay invested in the company.
- Equity grants inculcate a sense of ownership among employees. It is observed that holding equity in the company has a positive effect on the loyalty, efficiency, and productivity of employees
Manage Employee Equity on Eqvista
Employees are the foundation of any business. To honor them for their services and ensuring they are well compensated is a top priority for an entrepreneur. An employee equity program is a right step in this direction. However, in a growing business, recruits and exits are inevitable and it becomes complicated to track equity grants for each case. Moreover, the involvement of investors also entails equity distribution. This is why using sophisticated software such as Eqvista is the best bet.
Eqvista is an easy to learn, state of the art unified platform for all your equity needs. It is now super easy to simultaneously issue, track, and manage equity for multiple shareholders. These knowledge articles will help you understand our services better.