Equity Compensation in Startups
In this article, we discuss in length the important aspects of equity compensation and how it contributes to ease the overall cash-flow burden in a startup.
The startup market is a gold mine for innovation and opportunities. Though 90% of startups eventually fail, the ones who make it through are worth the effort. In 2018, there were 145 “active unicorns” in the U.S. alone collectively worth $555.9 billion. Of the many reasons behind startup failures, it is seen that 82% of them failed due to cash flow problems. Being cash-strapped from the early stages, the success of a startup depends on how well they manage their finances. Equity compensation plays a big role in this situation.
Startups are new businesses. But they cannot operate with entry-level employees. Just when the company has the lowest financial backup is when they need to hire the top talent in the industry. These talented professionals are already in high paying profiles. Thus a startup has to compete with lucrative salary compensation packages of stable paymasters to hire the right executive for their initial team. Equity compensation terms are the game-changer in this case.
What is equity compensation?
Equity compensation is a method of non-cash payment in exchange for services to a business. Based on the role and contribution, company shares are offered in addition to a basic cash component. This is commonly used to design salary packages for employees in startups and tech companies. It is also a common practice to offer equity to advisors, consultants, and strategic board members. Equity is primarily granted to employees in the form of stock options, stock awards, restricted stocks, and performance shares. All of these instruments represent share ownership in the company and have varying tax implications.
When a startup is incorporated, all shares are distributed among the founders. To create a provision for equity compensation for employees, founders must set aside a percentage of their shares to create an option pool. This is important to attract investors as well. Investors funding startups expect equity in return and will not agree to fund unless the startup has an option pool in place pre-money. This way, startup investors protect their share dilution post-money.
Why is equity compensation important for a startup?
Equity compensation weighs heavily on founder shares. Also, equity cannot be granted at random to anyone. It involves many legal implications and requires diligent documentation as well. Yet, why are startups leaning towards equity compensation?
- To conserve cash: Startups generally struggle to establish a comfortable cash flow. This phase sometimes extends beyond the first five-year mark. The different types of equity compensation reduce the burden of monthly cash expenses of hefty salary packages. This in turn brings stability to the startup finances.
- To hire top talent: Startups can never compete with corporate salary packages unless they include the equity component. Shares in a business have the potential to accelerate to a high value in a few years that generally surpasses the period cash-based salary. Besides, talented professionals see a direct connection between their work and the appreciating share value.
- To minimize employee turnover: Equity compensation terms are always accompanied by some form of vesting. Vesting imposes conditions for equity credit and generally either time or performance-based. As a result, employees have to serve their time and achieve performance milestones in the startup before they are eligible to own shares. Leaving mid-way in a vesting schedule forfeits their shares. Thus offering equity serves as a reliable method to keep employees invested in the business.
- Enhance employee involvement: In the initial stages, a startup is as good as its team. Business profits are driven by this base team. As the startup clocks stable profits, share value increases as well. Thus with equity compensation employees see a direct connection between their hard work and accelerating equity value. This enhances a sense of loyalty and commitment towards the business.
When should you offer equity compensation?
As great as the benefits of equity compensation are, timing is key. Sometimes founders give away a chunk of company stocks to friends, family, or initial stage consultants without foreseeing possibilities of business growth or future equity needs for recruitment and fundraising purposes. Thus the following points must be considered before deciding to part with equity:
- Company valuation: Equity cannot be issued without determining the actual company valuation. Though a professional 409a valuation is expensive in the initial stages of startup operations, yet it is better to do it to arrive at a reasonable share value, without which it is difficult to determine the worth of equity being diluted. A startup must consider equity compensation only after a proper company valuation.
- Business plans: Offering equity makes sense only if the value of equity has chances of accelerating over the years. Thus a startup must have a clear vision of its growth trajectory. Only if the business plans to attract venture capital and eventually plan a sale or an IPO, granting equity compensation to employees truly holds value.
- Option pool: Generally startups wait till the time the first investor pushes them to create an option pool pre-money. But as a strategy, a startup must be proactive in creating an option pool before designing equity compensation packages. There is no fixed rule regarding the size of an option pool, but 10 – 25% seems to be the norm.
- Vetted employee: Equity compensation terms grant equity holders the right to share ownership in the business. Depending on the type of shares, shareholders in turn have voting rights and access to important business documents. Thus a startup must do a proper background check of the employees, their performance records in the present, and previous organizations before confirming eligibility for equity.
Types of Equity Compensation
Equity compensation varies in the way they grant stock ownership. Each one of the plans has different tax implications and follows set exercise rules. Most of the equity schemes designed for employees are subject to vesting schedules; however, the vesting duration varies with employee needs. Here are the three most common equity compensation terms:
This provides employees the option to buy stock at a pre-set price at a later date once all stocks are vested. With this equity compensation, employees gain access to stock after working for a certain period in the company. The idea is, stock value appreciates over the years and employees profit from the difference between the exercise price and the actual market value of the shares on the date of sale. Employees with these options are considered as stockholders and not shareholders. There are two types of stock options:
- Incentive stock options (ISO): These are granted only to employees. One of the biggest advantages with ISO is that if employees adhere to a vesting period of a minimum of two years and a holding period of one-year post-exercise, the profits will be taxed as per capital gains rate instead of the regular high-income tax rate.
- Non-qualified stock options (NSO): These can be offered to anyone and not limited to employees. Though the gains are taxed as per regular income tax rates, NSOs are not required to adhere to any holding period.
Equity compensation terms for restricted stock grant actual stocks to the beneficiary as opposed to stock options that grant the rights to a stock purchase. But the employee cannot sell these stocks until completely vested. Although there is a restriction in the sale, the employee enjoys all benefits of stock ownership such as voting rights and dividends. Usually in the case of restricted stock, after the completion of the vesting period, all stocks are granted at once in bulk. Sometimes, a startup might choose a graded vesting. In that case, stock ownership is granted in equal monthly installments. Restricted stocks are generally reserved for senior executives.
Equity compensation terms for performance shares, as the name suggests, are based on specific performance conditions. For purposes of granting equity, broadly two types of conditions are used:
- Performance conditions: These conditions are based on financial goals such as Earnings per share (EPS) or Return on equity (ROE).
- Market conditions: This is based on the company’s performance in comparison to the market or a segment of a market. An example of such a condition is to compare the total shareholder’s return vs. the peers.
No matter which type of equity compensation terms is chosen, it must be clearly stated in the employee contract during issuance. Equity ownership is governed by IRS regulations and it is in the best interest of the startup and the employee to mutually understand the extent of the equity contract. Here are some basic terms to note while dealing with equity contracts.
Common Terms You Should Know in Equity Compensation
While discussing equity compensation terms, employees must understand the equity situation in the startup in terms of the total number of diluted shares and the historical acceleration of the company share value. Here we discuss some of the common terms used in these negotiations:
- Vesting period: This is the waiting period set by a startup before the employee receives the rights to stock purchase or ownership of shares. Vesting periods are normally between 4 – 6 years. There are three basic types of vesting: Immediate vesting, cliff vesting, and graded vesting. Based on the role and timing of recruitment, employees are granted equity compensation governed by one of the three vesting mechanisms.
- Cliff: A cliff is a probationary period set while designing equity compensation terms. It is a qualifying time set for an employee before which they are not eligible for stock vesting. Usually, the first year of employment is the cliff. This allows the startup to evaluate the employee’s performance and in extreme cases, termination if required.
- Grant date: The date on which equity is granted to employees is the grant date. However, this is not the date when the employee is eligible to exercise their options. This is only the starting date of the equity compensation terms.
- Grant price: This is the price at which equity is granted to an employee. This is the fair market value and depends on the stock value on the day of the grant. Employees always receive the benefit of a special rate different from the market price.
- Exercise price: This is the price at which an employee can exercise their options once all stocks are vested. This is the same as the grant price. But after a few years, if the company share value has consistently appreciated, the exercise price of shares will be much lower than the market price on that day.
- Exercise Date: This is the date on which an employee takes action on their shares. An exercise date can be set only after all shares have vested and the granted stock does not have any restrictions of a holding period.
- Expiration date: This is one of the most important features of equity compensation terms. Once all granted stocks are fully vested, the employee must exercise them before the expiration date. This is usually 8 – 12 months from the time stocks are fully vested. The employee stands to lose claims to all vested stocks if not exercised before the expiration date.
- Preference stack: This is the order of preference for payouts in case a startup is acquired or goes public. Common shareholders are the last in the pecking order while the preferred shareholders (usually investors) are the first in line.
- Liquidity event: This is any particular event that results in the cashing of equity. Usually, an acquisition or an IPO are referred to as liquidity events. The concept of preference stacks come into play in such situations.
Taxes for Equity Compensation
Different types of equity compensation have varying effects on the tax structure. For instance, ISOs are taxed as per capital gains rate while NSOs attract regular income tax rates. RSUs are also taxed similar to NSOs after all the stock is vested. Each of these schemes has underlying conditions that determine the overall flexibility of the scheme.
For example, let’s consider the concept of Alternative Minimum Tax (AMT). This is an extension of the tax breaks provided by ISOs where the profits are taxed as per capital gains rate if the employee adheres to the vesting and holding period conditions. If the regular tax value falls below the threshold of AMT, then the employees pay only the AMT. But if the regular tax is higher than the AMT, employees pay only the regular tax.
It is up to the recruitment team of a startup to use a combination of the different equity compensation terms along with the cash compensation to create an attractive package that not only eases the cash burden on the business, but aligns the employee’s financial interests to that of the company as well.
Manage Your Company Equity on Eqvista
As we see, equity compensation is quite an intricate process. In a startup, handling the cap table might be simple in the initial stages. But once investors start to join the mix and employee turnover triggers joining and termination clauses, managing equity manually becomes cumbersome and a risk process considering their legal implications. Hence it is best to use automated equity management software such as Eqvista that eases share issuance, tracking, and managing company equity.
Our state-of-the-art technology allows customized logins for company personnel and shareholders enabling easy access to share status in real-time along with the accompanying documentation. Here is the range of services offered by Eqvista. For more information, reach us today.