Overview - Equity for Employees in Early Stage Companies

In advising with early-stage firms, a constant concern by founders, employees, and students is the equity program made available to them. This blog post begins a series of posts on this matter with an overview of types of equity programs.

Common Questions by Employees

When employees consider equity compensation in startups, they often have many questions trying to understand the offer and its implications. Here are some of the common questions employees ask about equity programs:

1. What Kind of Equity Will I Get? - Employees are interested in understanding the type of equity they will receive, whether it be in the form of stock options, restricted stock units (RSUs), or another equity type, each of which carries different implications regarding ownership and taxation.

• Stock Options

  • Incentive Stock Options (ISOs): These options are designed for key employees, enabling them to buy company stock at a predetermined price in the future with specific tax advantages.

  • Non-Qualified Stock Options (NSOs): These options do not qualify for special tax treatment and are subject to taxation as ordinary income upon exercise. They offer more flexibility and can be extended to a broader employee base.

  • Restricted Stock Units (RSUs) - RSUs are grants that convert into company shares upon meeting specific conditions, such as vesting periods or performance goals. Unlike stock options, RSUs do not require the employee to buy the shares.

  • Employee Stock Purchase Plans - ESPPs enable employees to buy company stock at a discounted rate, typically through payroll deductions. These plans are commonly used by public companies and can be either qualified (providing tax benefits) or non-qualified.

  • Stock Appreciation Rights (SARs) - SARs offer employees a cash or stock bonus based on the rise in the company's stock price over a specified period. This scheme does not necessitate employees to purchase stock, thereby avoiding immediate tax consequences.

  • Phantom Stock - Phantom stock plans offer employees cash bonuses that reflect the value of a specific number of shares. These plans do not involve actual stock ownership and are frequently used to incentivize employees without diluting the equity of existing shareholders.

2. What Proportion of the Company Do the Shares Account For? -

Understanding the ownership represented by shares granted to employees is crucial for evaluating their equity stake in a company, influencing their level of influence and decision-making authority.

The percentage of shares held by employees impacts their financial interests, aligning incentives with company performance and fostering dedication to mutual objectives.

Comprehending the company shares owned provides insights into the organization's well-being and stability, shaping perceptions of long-term prospects and confidence in future success.

3. What is the Vesting Schedule? - Employees need to know the vesting schedule, which dictates when they will gain full ownership of their equity. Most equity plans include a vesting schedule, which determines when employees gain full ownership of their equity. A common schedule is four years with a one-year cliff, meaning 25% of the equity vests after one year, with the remainder vesting monthly or quarterly over the next three years.

4. How Much Dilution Can I Expect? - Employees are concerned about dilution, which occurs when new shares are issued, reducing the percentage of the company they own. They often ask about future funding rounds and how this might affect their equity.

5. What is the Company's Current Valuation? - Knowing the current valuation helps employees estimate the potential value of their equity. When evaluating employee equity programs like options in startup companies, there are several key factors to consider regarding their potential value

• The current valuation of the company and its projected growth trajectory are crucial. Look at metrics like: Last round valuation, Revenue growth rate, Market size and opportunity, and Competitive positioning

• Company financial health - Review key metrics like revenue, burn rate, and cash on hand to assess the company's financial stability.

• Finally, exit scenarios - The ultimate value depends on if and how the company exits. Exits can be IPOs, Acquisitions, Buybacks and other means.

6. Are There Any Conditions for Exercising Options? - Employees need to understand the conditions under which they can exercise their options, such as whether early exercise is allowed or if there are restrictions after leaving the company.

7. Is There Acceleration of Vesting if the Company is Acquired? - Employees may inquire whether their vesting schedule accelerates in the event of an acquisition. Acceleration allows the employee to receive all the remaining shares at the time of the acquisition or other event instead of having to wait the remainder of the schedule.

8. What are the Tax Implications? - Understanding the tax consequences of different types of equity. Whether the equity or equivalent can qualify as capital gains, was it held long enough to qualify as capital gains, what are the federal and state income tax implications, etc? One of the biggest concerns is holding stock options (non-qualified or NSOs) and the tax implications upon exercise.

9. How much 'equity' should the founding team set aside for employees? There is no specific amount required, but most firms follow 'rule of thumb' conventions. Here are some key points about how much equity startups typically set aside for employee stock option pools:

The most common range is 10-20% of total equity set aside for the employee option pool with many sources citing 15% as a typical or average amount. The exact amount can vary based on factors like:

- Company stage/valuation

- Number and level of planned hires

- Geography (e.g. US vs Europe)

- Investor expectations

Setting aside too much can unnecessarily dilute founders, while too little may require topping up later. The pool size can be increased later if needed, so starting smaller (e.g. 10%) and increasing as required is often advised.

Conclusion

Equity compensation is a powerful tool for startups to incentivize and align employees with company success. It fosters ownership, commitment, motivation, productivity, and loyalty. Employers must design fair and transparent plans aligned with company goals. Employees should understand risks, rewards, fluctuations, and tax implications of equity compensation.

Over the next several blog posts, I'll delve into most of the questions here in greater detail.