In a startup’s early days, nothing matters more than attracting and retaining talent. That said, it’s important to attract the right talent. Employees who feel vested and part of the team are more committed to their companies. Equity plays a key role in aligning incentives, clarifying expectations, and deliverables between companies and employees. Annie Webber, Founder and CEO of LegalHero, and David Ehrenberg, Founder and CEO of EGFS, took us through the ins and out of Sharing the Pie.
3 most common ways to make equity grants:
1. Stock options: give users the right to purchase sales in the future at a price specified on the date of the option grant.
2. Restricted stock: an outright grant of shares that is issued subject to certain restrictions.
3. Restricted stock units (RSUs): represent a (non-forfeitable) right to receive shares once restrictions have been met.
There are other ways to give equity: they can take the form of stock appreciation rights which confer the right to receive cash or stock based on the increase in company value, and phantom stock plans, but they are rarely seen with startups.
Now that you know the most common forms of equity grants, how do you figure out the right vehicle for your startup?
Equity Grants And Taxes
Why file an 83(b)?
Restricted stock is subject to taxation while it vests. 83(b) provides a way to avoid short-term taxation on stock grants that involve future vesting by letting you purchase restricted stock when you receive it — as long as you make the election within the first 30 days after you receive the stock. If you expect your grant to be worth more in the future, think about doing the election immediately after you get the restricted stock.
It is rare for founders not to file an 83(b). The only reason not to make the election would be to avoid the capital outlay of the initial stock purchase, especially if you don’t think/believe the company’s value will increase.
NSOs And ISOs: What’s the Difference?
ISOs (incentive stock options) can only be granted to employees. They allow more flexibility with your tax strategy because they are not taxable at vesting. Also, they have a lower tax burden than NSOs do because they are not subject to ordinary income tax on the difference in value between the exercise price and the fair market value (FMV) of the stock.
NSOs (non-qualified stock options) can be granted to anyone, not just employees. They are taxable at vesting. NSOs are commonly used to compensate consultants, board members, and directors.
Structuring equity grants — Standard terms
The way equity is structured can be far more important than the total amount given. Here are standard terms you should expect to see included in stock plans:
Vesting — The process by which you accrue non-forfeitable rights to equity. Vesting protects companies from founders and employees who leave early and rewards those who stay for the long-term. Founder vesting is also a requirement for many VCs.
The current industry standard is a four year schedule with monthly vesting over that period and a one year cliff. The cliff is the time period that must pass before any founders’ or employee’s equity vests.
Transfer restrictions — Determine when stock may be sold or transferred and to whom. The purpose is to control the company’s stock ownership.
Right of First Refusal (ROFR) — Gives company the right to buy stock that’s being transferred.
Repurchase rights — Gives company the right to buy back stock. Allows company to reward future employees without diluting stock.
Termination provisions — Options usually have a 10 year expiration date but that can be adjusted based on the circumstances of an employee’s departure. For example, employees who leave typically have 30 days to exercise their options versus 90 days for those fired without cause and immediate expiration for those fired with cause.
Accelerated vesting — Options vest immediately if certain events occur. This can be structured as single or double “trigger.” For example, options vest if the company is acquired or they vest if the company is acquired and the employee is fired as a result.
For most startups, equity grants are a key part of compensation. They also impact valuation and are a factor in negotiating startup financing terms with investors. It pays to have a good understanding of how they work and which ones to offer when.
Deborah Adeyanju is Content Strategist & Social Media Manager at Early Growth Financial Services (EGFS), an outsourced financial services firm that provides small to mid-sized companies with day-to-day accounting, strategic finance, CFO, tax, and valuation services and support. Prior to joining EGFS, Deborah spent more than a decade as an investment analyst and portfolio manager with leading financial institutions in New York, London, and Paris. Deborah is also a Chartered Financial Analyst (CFA) charterholder.