Equity Incentive Plan for Startups
In this article, we discuss the nuances of offering equity incentives in startups.
A startup business by nature is cash-strapped in the initial stages. The ensuing pandemic has only made matters worse by altering global economies in a way that securing funds for startups is a much bigger challenge today. For example in the US, unless a startup is based in some of the geographical hotspots preferred by investors, securing the right funding is not an easy task. But how does a startup operate elsewhere? Should innovation and growth be limited by insufficient funds? How does an entrepreneur recruit the much needed human resources to drive their business?
Equity Incentive Plan
An equity incentive plan is an irreplaceable recruitment tool for a startup. It is a well-known fact that it takes a while for a startup business to establish a comfortable cash flow. Fundraising for startups is truly an art that entrepreneurs take a while to understand. Until then startups have to adopt the bootstrapping strategy. So how does an equity incentive plan fit into this?
What is an equity incentive plan?
Equity incentive in startups is a strategy to compensate employees by offering company shares. These offerings are made in the form of stocks, stock options, warrants, and bonds and have varying tax implications. Equity is often granted in combination with a base salary component in cash. Though an employee receives the cash component as a monthly salary, equity is subjected to certain conditions governed by vesting schedules spread over at least 3 – 6 years.
To create an equity incentive plan, the founders must make provisions right at the start of business operations. In the initial stages, all company shares are distributed among the founders. Thus to create equity incentive plans, founders must set aside a percentage of their shares in an ‘option pool’. It is better to do this in the early stages because right from the seed round, investors prefer business models that already have a clear vision for their equity incentives. Investors mostly insist on a pre-money option pool so that their shares do not get diluted after investment.
Why do startups offer equity incentive plans?
As we see, equity incentives in startups are issued from the option pool created by diluting founder shares. Considering that founders created the company, and probably invested most of their assets into the initial funding, what is the logic behind diluting their shares? Why do the founders agree to share their profits? Here are some possible advantages:
- Cash conservation – Salaries are a regular expense to the company. In a startup situation where cash flow is problematic, offering equity incentives reduces the burden of a monthly cash-based salary system. This contributes to the overall profitability and flexibility of the company finances.
- Recruit top talent – The startup industry is very competitive. The top talents not only have the option of joining an established company with lucrative incentives, but these resources also have an array of startup equity offers to choose from. Equity is the only method by which startups can compete with corporate salary offers. A well-designed equity incentive plan not only attracts the best talents in the industry, but also keeps them motivated to align and stay invested in business growth.
- Minimize employee turnover – Equity incentives in startups are offered subject to vesting schedules. In simple terms, vesting schedules detail the timeline for stock ownership. Since it distributes stock ownership over three to six years, employees have to continue working with the company to receive all the benefits. Also, employee contribution has a direct impact on stock prices. Thus, equity proves to be a powerful retention tool for employees as they see the direct value of their hard work.
When Should a Startup Create an Equity Incentive Plan?
Generally, startups wait till the first funding round before creating an equity incentive plan. Equity schemes for employees become a necessity in this situation as investors mostly refuse to come on board unless they are convinced that the startup already has made provisions for employee equity incentives from their existing share pool. In this way, investors protect themselves from post-money share dilution. If a startup is not ready, pressure mounts to create an equity scheme at the cost of massive cuts in founder shares.
Thus it is better to prepare for equity incentive in a startup in the initial stages of company formation. Founders do not have to face investor pressures at this stage and have the opportunity to create a sustainable equity plan. This early approach also adds value to the management’s foresightedness which has the potential to provide a competitive edge during funding rounds. Some important points to note before planning equity incentive schemes are:
- Company valuation is a must. Private companies must get a 409a valuation done before finalizing the fair market value of share prices. This is the starting point. Equity grants are made at the fair market value on the grant date.
- Vesting conditions must be clearly defined. Be it time-based, the achievement of performance benchmarks, or any other condition, a clear definition of terms is important to avoid any legal disagreements at a later stage.
- Equity grants can be made only to existing employees. At no cost should company equity be extended to former employees or prospective ones.
- Equity can be granted only to an individual, never to any legal entity. This is especially important in the case of third party consultants. If a startup decides to grant equity to an individual consultant for their short-term services, it must be done only on clearance from the consulting firm.
How to incorporate vesting in your equity plan
The vesting process is implemented using a vesting schedule generally spanning 4 years. Also, the first year of employment is the ‘cliff period’. After an employee has crossed the cliff, 25% of the shares will be granted, and the remaining shares will start vesting in equal monthly increments.
Let’s imagine a new employee is granted 100 shares in January 2021. After the cliff, shares will start vesting over 4 years and in parts of 48 from Jan 2022. Here is a simple vesting schedule:
|12/48 25 shares
|24/48 50 Shares
|36/48 75 Shares
|48/48 100 shares
Besides, there is the concept of a ‘trigger’. As the name implies, a trigger sets in motion an array of events that may cut across ongoing vesting schedules and result in early vesting of shares. There are two types of triggers:
- Single trigger – When one event accelerates vesting, it is known as a single trigger. Mostly this happens in the case of a company sale. All employee shares vest in one shot and the employee is free to leave. This poses a threat to the acquirer as they not only have to pay the entire equity as per previous terms; they will have to re-work a fresh compensation package to retain key employees who are assets to the business.
- Double trigger – Two events accelerate vesting in this case. The first being a company sale and the second is the involuntary termination of an employee within 9 – 18 months of acquisition. Double triggers are the preferred strategy as it protects both the employees and the acquirer from knee-jerk shifts. Employees have the opportunity to continue with the new business and the acquirer manages to continue business as usual for at least the first 12 months of acquisition before facing dilution and parting with equity or any key employees.
As we see, incorporating vesting in a startup equity incentive plan not only spaces out the burden of equity credits, but also keeps the employee motivated to maintain their stellar performance throughout their time in the company. As the startup grows in the next five years, share value accelerates as well, and the employee gains from the increased share value five years after their employment instead of the initial value at their joining date. With vesting, a startup also gets the necessary time to evaluate an employee for a long-term association since the grant of shares will eventually make the employee a legal shareholder in the company with access to business documents and voting rights.
Equity Incentive Plan Options
Since equity incentive in startups potentially creates shareholders in the company, care must be taken with the grants. There are various types of equity grants, with each one offering different taxation (IRS considers both cash and equity taxable) and ownership rights. In this section, we discuss some of the commonly granted forms of equity plans:
Qualified incentive stock option (ISO)
The incentive stock option (ISO) is a form of an equity incentive plan that allows an employee to purchase the granted shares at a set price at a later date. This pre-set price is the fair market value of the shares on the grant date. On a later date, when employees exercise the options, considering share value has accelerated, they profit from the difference. Profits thus made in ISOs are taxable as per capital gains rate rather than the higher regular income tax rate. But to access the special capital gains rate, ISOs require a vesting period of a minimum of 2 years and a holding period of more than one year before they can be sold. This type of equity incentives is generally granted to key employees.
Non-Qualified incentive stock option (NSO)
NSOs on the other hand is not restricted to only employees. They are referred to as non-qualified stock options as they do not need to adhere to all requirements of the Internal Revenue Code. Though NSOs incur regular income tax, they are far more flexible to use as they can be granted not only to employees, but strategic advisors and consultants as well. Besides, NSOs are not bound by the holding period restrictions.
Stock appreciation rights (SAR)
SARs are a special group as an equity incentive in startups. Unlike stock options, they are granted in cash. Employees are not required to pay any exercise price for SARs. They are normally granted along with stock options and in turn help in funding the purchase of options and pay for the taxes arising from it. Taxation for SARs is similar to NSOs. This is the best way to grant the profits from an increased stock price without granting actual stock.
Also known as ‘synthetic equity’, phantom stocks are usually granted to select high-value employees without granting actual stock. Using this equity incentive plan, a startup grants the value and benefits of stock to the employee without granting rights over their stocks. This works as a strategy to compensate for a high-net-worth employee without diluting company stock. Phantom stocks are not bound by any pre-set requirements or restrictions except those set by the IRS code 409(a).
Offering Equity Incentives
Offering equity incentives is quite a tricky affair. The best-talented resources and top-notch investors cannot be attracted without equity schemes. On the other hand, with every recruitment and funding round, founder shares face dilution. Besides, every equity grant is potentially an invitation to be a shareholder in the company with voting rights. Thus, startups need to be careful in designing equity incentive plans.
To whom you offer equity incentives in a startup
A startup is like a child on a growth spurt. Strategies that work in the first year may not in the fifth. The same goes for the equity incentive plan. It is a given that equity is the strongest currency in the startup arsenal to recruit and incentivize key employees. But two important factors must be considered before granting equity to employees:
- Role in the business – Like regular salary compensation, the equity component varies with the role of an employee in the company hierarchy. For example, senior technical staff may be granted 1%, while the same profile at the mid-management level may receive 0.35% and an entry-level position receives 0.15%. The same logic applies to advisors and consultants and their extent of engagement in the startup.
- Timing of recruitment – This is the most important determinant in offering equity incentives in a startup. When VP Marketing joins as the 3rd employee in a startup, he is almost a co-founder and may receive almost 10% equity. Meanwhile, if similar recruitment is made 5 years later when the startup has a product in the market generating sales, the same profile will receive 1- 2% which in monetary value will be of substantial worth.
How many shares are subject to an equity incentive plan?
This is need-based. There is no set quota for the option pool. However, it is seen that the percentage varies between 10 – 25%. It is better to start small and expand as per requirement. Besides, at every funding round, investors will request refreshing the option pool. Here are some factors that may help in designing an efficient equity incentive plan:
- Recruitment plan for the next 8 – 12 months, especially senior roles
- Current funding levels of the business and prospective funding rounds
- A clear understanding of the business stage
- Projected equity value in the next couple of years
- The extent to which existing shareholders are willing to dilute their shares
- Status of revenue and profit of the business
- Equity policy for external consultants, advisors, third-party service providers
Based on all the above considerations, a modern equity incentive plan must account for the following important features:
- Make provisions for all types of equity grants at the very beginning to avoid seeking repeated shareholder permissions
- The equity plan administration board must have complete authority to determine the key terms and conditions of every equity award
- The clarity in terms governing dividend payouts
- Understanding of the size of option pool, provisions of section 162(m), and the consecutive dilution effect
- Terms governing minimum vesting requirements and triggers
- Definition and effect of ‘change-in-control’ situations
- Tax withholdings
- Clawback provisions and prohibiting re-pricing
- Protection of participant rights
Equity incentive in startups is an important component of the business. The nuances of it are intricate and cumbersome for a startup to manually manage in-house. Automated software such as Eqvista is best suited for varied equity management needs.
Our user-friendly interface facilitates all activities related to company valuations, cap tables, share issuance, tracking, and managing company equity. Read more about our software features here. To know more, connect with us today.