Issuing Employee Equity
Many startup companies offer company equity to their employees as part of an overall compensation package. Equity can be attractive to employees, particularly early stage employees, due to the potential for growth in the value of the equity and the sense of being invested in a company of which they own a piece. Companies that want to start issuing equity have many issues to consider, some of which are listed below:
WHEN: Companies should be thinking about issuing employee equity from day one. Employees will see a greater upside if they receive their equity when the price is low, and are able to sell it years down the road when the price is (hopefully) greater.
HOW: Issuing employee equity will generally require approval by the board of directors or managers of the company. The company will need a plan, such as an omnibus incentive plan or an employee stock option plan, that will contain all of the terms and conditions applicable to the equity, as well as key terms regarding tax treatment and other issues.
HOW MUCH: Typical startups will set aside 10-15 percent of their shares or units for the employee equity plan. But this can vary, and depends on the individual needs of the company. It is ideal to set aside enough equity early on to avoid having to re-authorize more shares later. Companies can also set up their plan to auto-increase by a certain amount each year, subject to applicable IRS regulations.
WHAT TYPE: While options are a popular type of employee equity, companies can also issue restricted stock units (RSU) and other forms of equity. With an option, the employee has to pay to exercise their equity, at which time they receive shares in the company. With an RSU, the employee does not have to pay anything up front for their equity. Each type of equity has different tax ramifications for both the company and the employee.
WHAT ARE OTHER KEY TERMS: Equity is generally subject to vesting, meaning that 100 percent of the equity is not available immediately. A typical vesting schedule has the equity vesting over four years with a one year cliff. That means that once an employee has received an equity award, they must remain employed for a year before they vest in a percentage of the equity awarded. The remaining portions get awarded on every anniversary thereafter until 100 percent is fully vested. Companies can also choose to accelerate vesting if the company is sold or goes public. For stock options, companies can choose to offer early exercise, meaning that an employee can pay for their options before they are vested, potentially lowering their tax liability.
There are numerous legal and business considerations that come into play when creating an equity incentive plan and issuing equity to employees. Smart Counsel can advise you through this process.