Equity Based Compensation: Intro
JUNE 27TH, 2017
One of the most important issues associated with any startup is employee equity. Most employees join a startup with an expectation of receiving equity in the company.
Employee equity aligns the entire startup team, as everyone looks forward to his/her payday at the exit event. The vast majority of venture term sheets will contain a section stipulating either the creation of, or replenishment of, an Employee Stock Option Plan (ESOP). A typical ESOP pool is 15% of total equity, but this number can move as high as 20% and as low as 5-10%.
Most people immediately think of stock options when the topic of employee equity arises, however there are many variations of equity based compensation (especially in the case of a startup).
Stock Options. The most common type of employee equity. It is called a stock ‘option’ because the employee has the option to buy the common stock at some point in the future. The option is issued with a 'strike price’, and the option will be in the money if the actual value of the common share is higher than the strike price.
Restricted stock. Is actual common stock that is issued to an employee with restrictions on when the employee can sell or transfer ownership of the stock. Unlike options, the employee owns the shares from the day they are issued, and are subject to capital gains upon the sale of the stock (usually at the time of an exit event).
Restricted Stock Units. A promise to issue common stock upon a vesting schedule. Like restricted stock, the employee owns the RSU once vested, but there are commonly triggers (such as an exit event) that automatically transfer ownership. This can have the impact of alleviating tax implications associated with restricted stock.
Phantom Stock/Profits Interest. The employee gets the value of a hypothetical number of shares, with stock appreciation rights. The awards vest over time or on the achievement of some target (or both). The award can be paid in cash, the company can take all the relevant taxes out of the award and give the employee the remaining net. The employee is typically entitled to receive a pro-rata share of cash distributions, and to participate pro-rata in an exit event. From a tax standpoint, Profits Interests are advantageous to the employee, as the employee has zero front-end tax implications (because no stock has actually been granted). Tax implications arise upon cash distributions and an exit event.
Employee equity can be a complicated topic. Entrepreneurs can cost themselves large amounts of exit value, and employees can be confused by what they’re actually receiving as part of their compensation package. If structured correctly, ESOP plans can motivate a startup team, and provide value to the company in excess of the 15% (or so) equity stake that it has 'given’ to employees.
