Start-up Employee Equity
For a better understanding let’s take a closer look at the concept of equity compensation.
Startups are an exciting business prospect. As creative and dynamic as the venture may be, in the initial stages, cash flow remains a challenge by design. In this scenario, equity compensation for startup employees is an important strategy to hire and retain the promising talent required to drive a business. But as an entrepreneur, one must understand the nuances of it before deciding to distribute company equity.
Startup Employee Equity
The decision to join a startup is always a risky business. The company is just starting out and despite the brilliant business idea, who can say how the future pans out. In comparison to an established company that is a stable paymaster, why would a talented professional choose to join a startup? Matching the compensation package is no longer the deciding factor as in terms of stability, a startup will lose out. But when equity is brought into the picture, the rules of the game tend to change. Let’s see how.
What is equity compensation?
Equity compensation for startup employees is a recruitment strategy where a percentage of company equity is offered as part of the employee remuneration package. It is seldom a complete replacement of the cash component, rather an addition to the base salary in cash. In the early stages of operations, when a startup is cash strapped and has to prioritize cash flow, equity acts as a super currency in recruitments. These days, equity compensation has become a norm in startup job offers.
The greatest advantage of equity is that employees become a part of the company. Apart from the thrill of creating something from scratch, holding shares in a startup acts as an incentive to stay invested in business growth. Employees can see their hard work directly reflected in business profits. This works as a great motivator for creative minds who see immediate results of their long hours as compared to being lost in the hierarchy of a massive corporation. Also, startup employee equity value increases as the company grows. Employees reap massive profits when they exercise options after years.
Startups thus use equity as an important attraction and retention tool. Over the years, by trial and error, entrepreneurs have got a hang of this strategy. Startup employee equity value is usually higher for the first ten employees and gradually diminishes as the company grows. Meanwhile, company valuation increases with time. So a startup founder must account for such contradicting factors before issuing equity.
Why is offering equity for startup employees a good idea?
Statistics indicate that close to 90% of startups fail within the first year of operations. Mismanagement of finances is one of the top reasons for it. Be it the founders or a new heavyweight executive team on board, all are equally accountable for making intelligent decisions for the business. Thus hiring ‘A grade’ employees is advisable. But how can a startup compete with established companies in recruiting top talent? Startup employee equity is the way to go. Here are the top advantages of offering equity to startup employees:
Startups align all operational strategies to preserve cash expenses in every way possible and channel profits back into the company. Thus they cannot afford to have a heavy recurring cash expense towards the employee salary component. As a practice, it is seen that close to 15% of company equity is reserved for recruitment purposes. Once the company continues to grow and make profits, on payday even the smallest percentage of company equity has the potential to be more valuable than the regular salary in cash. This is one of the lucrative advantages of early-stage startup employee equity.
Hire and retain best talent
With a fast-evolving startup culture, many top professionals are taking the risk of stepping out of their comfort zones of a monthly paycheck to experiment with new challenges. However, it is quite a risk and this risk is balanced by equity grants in the startup. In addition to the offered role, competitive equity compensation acts as a deciding factor in startup recruitment.
When should you offer equity to startup employees?
As great as startup employee equity is, founders must have a clear vision regarding who is worth a share in their company. By granting equity, a startup is practically issuing ownership in the business. For sure, not every employee is eligible for it. Here are some factors that help determine equity eligibility:
Where is your startup headed
Before issuing equity compensation for startup employees, founders must ask themselves some basic questions regarding the future path of the company. If the route is leading to accelerated growth with plans to involve venture capital within the next couple of years, the startup will need one of the best talent pools of professionals who will stay invested in the business for the long term. Such a team is self-driven, is passionate about the company’s product and service, and will stay committed to the company. It makes sense to share ownership with such resources as they will treat the company as one of their own.
From an employee’s perspective, agreeing to early-stage startup employee equity compensation balances out the risk of joining early. Also, a startup with a dynamic vision is on a sure path to profit. Employee shares will amount to a massive payday once vested.
Is the employee worth it
Once a startup’s direction is set, the next important question founders must ask themselves is, if their recruits are worth the startup employee equity. To make this decision, a sufficient background check must be done before finalizing a candidate. Check for their reputation in the industry, their contributions to a previous business they were associated with, and finally observe their performance in the company before transferring ownership rights.
It is important to remember that with ownership rights, employees become shareholders in the company with voting rights as well. So in addition to their resume, a lot depends on the employee’s personality and business acumen. While granting shares, founders must know that they are potentially inviting a new shareholder on board.
Types of Equity Offering to Startup Employees
Equity compensation for startup employees invokes many taxations and equity ownership regulatory requirements. Thus stocks cannot be granted at random. Certain processes have evolved by which startups are allowed to grant company equity to their employees. Here are two basic formats:
As the name suggests, this grant provides employees with the option and right to buy company stocks at a special rate, but not the stock itself. These stocks are granted at a special price called the ‘strike rate’. Invariably a vesting schedule is applied which is usually 4 – 6 years. Once all stocks are vested, the employee has the option to buy these stocks at the ‘strike rate’ which by then is much lower than the actual share value. After purchase, on exercising these stocks before the expiration date, the employee profits from the difference. The advantage of issuing stock options is:
- On the grant date, the startup only grants the option to buy stocks, not ownership of the stock itself
- Vesting schedules encourage loyalty, commitment, and performance standards in employees
- Employees have the flexibility to either buy or deny their shares. If the stock prices soar over the years, buying at the strike price and exercising them at market price is profitable. However, if share prices fall, employees are not stuck with devalued shares
Unlike stock options, restricted stock provides ownership to the entire equity share in one go. However, vesting schedules are implied. This category of startup employee equity is reserved for C-suite executives and top professionals with years of industry experience. Restricted stock can be used as a good sign-up bonus and an incentive program as well. Once vested, ownership to the entire stock is provided to the employee at once and they officially become shareholders in the company. They do not need to ‘buy’ any shares.
While discussing equity compensation for startup employees, a lot is riding on vesting schedules. Vesting schedules act as a safety plug that protects startup equity from a hit and run scenario with new employees. Here is how it works:
What is a vesting schedule?
Vesting is the process of providing contractual benefits to employees. Startup employee equity is granted based on certain restrictions or milestones. The timeline used for the vesting process is known as the vesting schedule. To understand vesting schedules, one must know these three important terms:
- Cliff – The cliff period or simply the cliff is the trial zone for new employees. It is usually the first year of employment. Only after completion of the cliff, an employee is eligible for the equity offer. If an employee chooses to leave before the completion of the cliff period, they forfeit the right to all shares.
- Vesting period – This is the time set for employees during which their stock will vest. The commonly used vesting period is 4 years with a one year cliff. In graded vesting, the employee gains rights over a certain percentage of stocks at the end of every financial year. All stocks are vested at the end of 4 years. Instead of granting all stock on one go, vesting schedules spread out the stock distribution.
- Expiration date – Once all stocks are vested, the expiration date is the date before which employees have to exercise all options.
How does vesting schedule impact employee equity offer?
Vesting schedules allow stock vesting in incremental monthly installments. Startup founders normally bear the responsibility of deciding the best vesting schedule for their business. Since a startup has varied employment needs in the growth phase, one rule for all employees is not practical. Normally vesting schedules follow this pattern:
- Founders and C-level executives – 25% is offered as a sign-up bonus while the rest vested in installments over three to four years.
- Consultants/advisors – Since their engagement is brief, these vesting schedules do not use cliffs. Stocks are vested in equal monthly installments over one or two years.
- Employees – Cliff is a must for regular employees. Usually, the first 25% is vested after completion of the cliff, and the rest vested in equal installments over 3 to 6 years.
The type of vesting schedule used in equity compensation for startups has a considerable impact on the employee offer. What suits the company may not work for the employee. After all, a startup is a risky venture and demands working in a highly stressful environment. It is difficult to attract the best talent unless they are sufficiently compensated. Here are the three popular types of vesting schedules:
- Immediate vesting – As implied by the term, this type of vesting schedule grants full ownership of stocks on a grant. There is no cliff or waiting period. This type of vesting is confidently used by elite professionals as an incentive to join a startup.
- Cliff vesting – This vesting schedule allows stock grants at one go after the cliff period which is usually the first year of employment. A cliff vesting period cannot exceed three years. If an employee chooses to leave any time before completion of the cliff period, they stand to lose all shares.
- Graded vesting – Startup employee equity offered through graded vesting includes a cliff as well as incremental stock credits. For eg, let’s say an employee is granted 100 shares using a graded vesting schedule of 4 years and a one year cliff. At the end of one year, the employee receives 25 shares, 50 shares are vested by the 2nd year, and so on until all 100 shares are vested after four years. If the employee chooses to leave in the third year, they will exit only with the fully vested 75 shares and forfeit the remaining 25.
Here is how the basic 4 year Graded Vesting Schedule would look if issued in 2020:
By the end of 2023, the shareholder would receive the total 100 shares of the grant per the vesting schedule.
Taxes for Employee Equity
Equity compensation for startup employees is governed by IRS and SEC guidelines. A startup must consult legal and tax professionals while designing equity compensation packages for their employees. It must be structured in a way that equity distribution does not harm the business in any way. Let’s take a closer look at the tax liabilities with ISOs and NSOs.
- ISO – Startup employee equity in the form of incentive stock options (ISO) are granted only to employees, mostly key contributors to the business. ISOs have a tax advantage as it does not trigger taxes on share transactions unless the employee decides to sell them. On sale, the differential amount between the strike rate and the selling price attracts taxes as per capital gains. There is a way to minimize this tax burden as well. Upon exercising, if the employee holds the stocks for two years from the date of grant and one year from the date of sale, they are eligible for a lower capital gains rate. Since the employee can choose the timing of ISO cash out, this is quite a flexible option in terms of tax planning.
- NSO – Non-qualified stock options are not limited to employees and can be granted to anyone. But they are taxed as per regular income tax regulation which is around 10 – 35%. In this case, the IRS does not differentiate between cash and equity. NSOs do not come with restrictions such as ISOs and are usually offered to third party consultants or specific board members.
Employee Equity Compensation and 409a Valuation
Equity compensations for startups cannot be designed unless the startup has undergone a 409a valuation. This is a mandate by the IRS. Unless a company is evaluated, share prices cannot be determined and without a validated share price, employee equity packages do not make sense. Thus, though a 409a valuation is an expensive process, it is better to get it done at the very beginning and avoid hefty fines and additional taxes at a later stage.
Create and Manage Employee Equity Plan on Eqvista
Issuing, tracking, and managing shares are a meticulous and cumbersome task. Equity compensation for startups involves several intricate processes such as managing cap tables, 409a valuations, equity plans, vesting schedules, and many more. Sophisticated software such as Eqvista allows automation of all these processes on one platform. Here is a list of services provided by Eqvista.