Equity and stock options are powerful incentives for attracting and retaining talent in your startup. But how do you decide how much to offer, who to offer it to, and what terms to use? In this article, you'll learn the basics of equity and stock options, the main factors to consider when designing your compensation plan, and some best practices to avoid common pitfalls.
Equity is the ownership share of your company that you grant to your team members, usually in the form of shares or units. Stock options are the right to buy a certain number of shares at a predetermined price (called the strike price) in the future, usually after meeting some vesting criteria. Both equity and stock options can have significant tax implications, so you should consult a tax professional before issuing them.
Equity and stock options can align the interests of your team with the long-term success of your startup. They can also motivate your team to work harder, smarter, and more creatively, as they have a stake in the outcome. Moreover, equity and stock options can help you compete for talent in a tight market, as they can supplement your cash compensation and offer potential upside if your startup grows in value.
In the world of startups, shares and options for employees (and related parties, like consultants), are often called ESOP (employee stock option program).
The amount of equity and stock options to offer is not a one-size-fits-all answer, as it depends on various factors such as startup stage, valuation, funding, growth potential, team size, role, seniority, performance, and market rates. Generally speaking, early-stage startups tend to offer more equity and stock options than later-stage startups due to having less cash and more risk. Founders usually get the largest equity stake followed by co-founders, key employees, advisors, and other employees. Equity and stock options are typically expressed as a percentage of the total shares outstanding rather than the total shares authorized. Furthermore, these are usually subject to vesting over four years with a one-year cliff before vesting begins. Additionally, equity and stock options are usually diluted over time since they represent a smaller percentage of the company as new shares are issued to investors, employees, or others.
As a rule of thumb, you might want to consider putting 10%-20% of the shares aside for your ESOP (employee stock option program).
The terms of equity and stock options can have a significant impact on their value and attractiveness. When deciding on these terms, you should consider the strike price, vesting schedule, expiration date, and transferability. The strike price should be set at the fair market value of the shares at the time of grant, as determined by an independent appraisal. The vesting schedule should balance the need to retain and reward your team with the need to protect your startup from losing equity. The expiration date should be reasonable and clear, as it affects liquidity and risk. Transferability should be restricted and controlled, as it affects ownership and governance of your startup. You may use a right of first refusal, a drag-along right, or a lock-up period to limit or prevent transfer without your consent.
Be sure to consult with a startup-experienced lawyer before issuing your ESOP. Since employee stock options and shares are about ownership rights, the recipients of these assets need to sign the same contracts (shareholder agreements) as all other owners. Failure to do so can have disastrous consequences when talking to professional investors or when selling the company (exit, trade sale).
Equity and stock options can be complex and challenging to manage, so you should follow some best practices to avoid legal, financial, or operational issues. Firstly, document everything; have a written agreement with each team member and have a stock plan that governs the overall administration and rules of your equity and stock options program. Additionally, keep an accurate and updated cap table that shows the ownership and dilution of your startup. Furthermore, communicate clearly; explain how equity and stock options work, how they are taxed, how they are affected by funding rounds or exits, and what they mean for personal and professional goals. Additionally, provide regular updates on your startup's performance and valuation as well as any changes or events that affect their equity and stock options. Lastly, seek expert advice from lawyers, accountants, consultants, or mentors who have experience in equity and stock options; they can help you design, implement, and optimize your equity and stock options plan while complying with legal, tax, and regulatory requirements.
A viable and significantly less complicated variant is so-called "phantom stocks." These are contracts between the company and the employees (and not an ownership title). These contracts describe how the company will compensate the employees for their efforts in certain situations. Very often, the arrangements are modeled after actual shares with the effect that the employees will, in case of an exit, get the same amount of money as if they owned actual shares. The significant advantage of phantom shares is that they are not an ownership title but a contract with significantly lower complexity and tax debts when issuing them. As always, check with your lawyers and potentially the tax office before issuing phantom stocks.
Issuing shares to employees creates a very complex situation between management and employees: Suddenly, the managed people become co-owners of the company. This might impact a manager's decision to promote or fire an employee. I've seen many situations where employees owning shares had trouble understanding and accepting their roles which consequently led to nasty, sometimes toxic, situations. Therefore, I'd strongly recommend phantom stocks instead of shares or options.