An incentive plan is a tool used to motivate and reward employees to grow a business and exceed goals. A common form of an incentive plan for startups is an equity incentive plan. An equity incentive plan rewards key employees with equity, which is ownership in a company. Equity can be a company’s stock if it is a corporation or its membership interest if it is a limited liability company. For startups, equity incentive plans can be a great way to motivate and retain early employees when the company does not have the financial resources to pay high salaries or large bonuses.
The concept behind the equity incentive plan is that employees are given equity when the value of the company is relatively low (because the company is just getting started and not yet profitable), but as the company grows and becomes profitable, the value of the equity grows and the holders realize large financial gains. The two most common forms of equity incentive plans are restricted stock and stock options.
Restricted stock is exactly that, stock in the company that is restricted by the company in some form. The most common restriction is “vesting”. Vesting is the process where the employee gains ownership of the stock over a period of time, most often a number of years. Vesting protects the company because it incentivizes employees to stay with the company instead of leaving for a different job. Depending on the details in the plan documents, if an employee leaves before his or her restricted stock has fully vested, he or she forfeits some or all of the restricted stock. For example, a startup may give an early employee 50 units of restricted stock in the company as a bonus but with the restriction that the stock does not “vest” with the employee for three years. If the employee leaves one year later, the company retains the restricted stock because the employee did not complete the three-year vesting process.
Stock options are the right to buy a certain number of shares of stock in the company at a set price, regardless of the current value of the stock. For startups, stock options can be another great way to reward and incentivize key employees. Most stock option plans include a vesting period like the restricted stock discussed above. Once vested, stock options allow the holders to realize financial gains if the company’s value has increased since the stock options were granted. For example, if the current value of a share of stock for a company is $10, the company can grant a stock option to an employee to purchase 100 shares of company stock at that $10 value. Once the employee’s stock option has vested, he or she would have a set period of time in order to exercise the option. If during the employee’s option period the value of a share of stock rises to $20, the employee can use the stock option to purchase the allotted 100 shares of the stock at the $10 option value and create a $1000 gain based on the option price paid versus the current value of the stock.
Both restricted stock plans and stock options allow startups to reward employees without jeopardizing the current financial status of the company. With the expectation that the company will succeed and grow in value, equity incentive plans can be a great benefit to both the employee and the company.
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