Startups typically issue equity as compensation to its employees to convince people to work at the company for what are typically below-average salaries. Therefore, equity can become a substantial part of an employee’s total compensation and can be a primary motivator for employees to work at your new startup. However, when you give equity as compensation you are going to need an equity incentive plan.
What is an equity incentive plan?
An equity plan, sometimes called an employee stock ownership plan (ESOP), is a structure that allows a company to award equity to any service provider, including employees. Not only does the equity incentive plan help reduce your administrative burdens, it also incentivizes the recipient to stay at the company and generate growth. This is because when you give equity to an employee, the employee now has skin in the game and will directly benefit from generating growth for the company.
When you are creating the incentive plan you will need to decide how many shares will be designated for the plan. Companies typically set aside 5%-20% of their fully diluted capitalization in an options pool for the equity incentive plan. It is more common for later stage companies to set aside the lower end of the range than early stage companies.
Equity incentive plans typically require approval from a company’s board of directors and are subject to federal and state-level securities laws and regulatory oversight that usually apply to private companies.
Types of equity incentives
Stock options are the most common type of incentive in the incentive structure. A stock option is the right (but not the obligation) to buy a certain number of shares of the company’s stock (usually its Common Stock) at a predetermined price, known as the strike price or exercise price. This price is typically equal to the fair market value of shares on the date of option issuance. Fair market value is often (but not always) calculated based on the company’s section 409a valuation at the date of grant.
There are two types of stock options for your equity incentive plan, incentive stock options (ISO) and non-qualified stock options (NQSOs or NSOs). ISOs can only be awarded to employees and have certain tax breaks that are not applicable to NQSOs. NQSOs can be awarded to any service providers and do not come with the tax benefits of ISOs.
Restricted stock units (RSUs) are an unsecured and unfunded promise for a right to receive a share of the company’s stock in the future. These shares are not actually issued on the grant date which means an RSU holder is not entitled to voting and dividend rights. RSUs can be settled by delivering the actual shares or the cash equivalent of the shares’ value. If the RSU is settled in shares, then the holder are entitled to rights.
RSUs are tax driven and typically more suitable for later stage companies.
Stock appreciation rights (SARs) entitle the recipient to the appreciation of the underlying value of the shares. SARs are usually settled in cash but could also be settled with shares or some combination of the two. SARs that are settled in stocks are settled in the same way as stock options.
Employee stock purchase plans (ESPP) allows the employee to purchase company shares at a discounted price. Employees take a payroll deduction to contribute towards the plan between the offering date and purchasing date. When the purchasing date arrives, the company will purchase shares on behalf of the employee using the funds from payroll deduction.
There are two types of ESPP: qualified and nonqualified. Qualified ESPP require shareholder approval before implementation and participants have equal rights in the plan. The offering period, the time between offering date and purchasing date, must be less than three years and there are restrictions on the discounts allowed for purchasing the shares.
Non-qualified ESPP do not have the restrictions that come with qualified ESPP. However, non-qualified ESPP are not entitled to after-tax deductions that qualified ESPP have.
Vesting and acceleration of an Equity Incentive Plan
One of the concerns founders have when issuing equity awards to an employee is ensuring that the employee stays at the company long enough to earn the equity that has been issued to them. For example, you would not want an employee working at the company for four years to receive the same amount of equity as someone who only worked at the company for one month. To resolve this issue, there are different ways to set up your equity incentive plan to ensure that the equity issued is effectively and fairly compensating your employees.
Stock awards granted under the equity incentive plan are subject to timing requirements called a vesting period. Recipients are subject to wait for a certain timing or performance goal to be completed before they are entitled to receive equity compensation. Equity compensation is meant to be incentive compensation so it is structured to incentivize employees to stay and generate growth for the company.
For example, employees usually need to stay with the company for one year before they have the right to exercise their stock options. At the one year mark (also known as the “vesting cliff”), they can purchase a portion of the shares that were issued to them under the equity incentive plan. After the one year mark, shares will typically vest proportionally to the time passed whether it’s monthly or yearly. (For more on the subject, check out our article, "How Vesting Schedules Work–and What They Mean for Founders".)
Vesting takes time, and during that period of time different events can happen to a company that may make the existing vesting schedule ineffective at incentivizing employees to continue working at the company. Remember, the vesting schedule and equity grants are all incentives for the employee to work for below average pay at your company.
If an employee or other service provider ends their relationship with the company, they forfeit their rights to equity that has not yet vested. If they opted to exercise their options early, pursuant to an 83(b) election, the company then repurchases unvested shares at the exercise price paid by the stockholder at the time of exercise.
When the current vesting schedule is not doing what it is supposed to do you may need to accelerate your employee’s vesting schedule. Accelerated vesting is when an employee is allowed to speed up the schedule to gain access to restricted company stock or stock options. For example, a vesting schedule over a period of four years may be vested by year three to be used as an effective incentive.
Accelerated vesting is typically triggered by the sale of a company or other change in its control, such as when a company goes public. You will want to accelerate your key employees’ vesting schedule in the first event to ensure that they stay until and through the company’s sale. In the second event, you may want to accelerate the vesting schedule to ensure that your employee is being properly compensated as is the point of equity compensation.
You can specify which events would trigger an accelerated vesting schedule, called trigger events, in the employee option plan. This way you will not need to negotiate with your employees when the trigger event happens, thereby eliminating administrative burdens for you. Just make sure these trigger events are clearly written in the employee compensation plan.
- Having an equity incentive plan is important to incentivize employees to work for you and to reduce your own administrative burden
- There are many different ways to set up your equity incentive plan and you should choose one that makes the most sense for your company
- Your equity incentive plan can attract investors because it shows that you are seeking to attract and retain a quality workforce
Written by Beth Zhao
Beth is a second year law student at The George Washington Law School. She is a member of the Public Contract Law Journal.