Equity compensation – which links the self-interests of a company’s service providers with the interests of the company and its investors – is a compelling incentive for start-up companies to attract and motivate employees and consultants. Many of these employees and consultants understand and expect that equity or phantom equity arrangements will make up a larger portion of their overall compensation than employees at more mature companies. There are a host of considerations involved in designing and granting awards under an equity incentive plan, and here are five important ones.
Decide what type of equity award to issue.
The two most common types of equity incentive awards that private companies offer are restricted stock and stock options. Both restricted stock and stock options offer the potential for considerable financial gain if the company experiences a liquidity event, but there are important differences between the two.
Restricted shares (which are full-value awards) are shares of company common stock that are granted subject to vesting and other forfeiture conditions. The conditions could be time-based (e.g., the shares vest in equal monthly installments if the recipient continues to work at the company) or performance-based, where the recipient must achieve certain performance metrics to vest in the shares.
Stock options (which are appreciation-type awards) are contracts that allow individuals to buy a specified number of common shares in the company they work for at a fixed price equal to the fair market value of the company on the date the option is granted. The fixed price is called the strike price of an option. If the value of the company’s common stock increases, the difference between the then-current fair market value of the company’s common stock and the strike price is called the spread. When the spread is positive, stock options are considered to be in the money. Similar to restricted stock, unvested options are almost always forfeited when an employee leaves the company, and any vested options must be exercised within a certain period (generally, 90 days).
Be discerning in setting up your equity pool and making grants.
Founders should agree at the outset on a rough percentage of their company’s shares or units that will be reserved for equity incentive awards. For example, an equity incentive pool of between 10-15% of a company’s shares or units is not uncommon, with significant portions of that pool reserved for key hires (e.g., a CEO or CTO). The terms applicable to equity awards are set forth in a formal plan document and in an award agreement, the latter of which typically sets forth the vesting schedule applicable to the award and other terms that may vary among participants. Companies should also aim to establish consistent practices across their employee roster and be mindful of the incentive compensation terms competitors are offering.
Be careful in how you promise equity awards to employees and consultants.
When a new hire is brought on board, companies will often describe the terms in an offer letter, email, or via verbal agreement. To prevent disagreements down the road and adhere to certain legal requirements, it is important to make an offer of equity in writing, indicate that the offer is subject to the approval of the company’s board, describe the terms (e.g., number of shares, vesting schedule), and state that the grant will be subject to the terms and conditions of your company’s incentive plan and form of award agreement. For several reasons, grants generally should not be made to a future employee or consultant before the date they commence providing services to the company.
Exercise caution in setting the strike price of an option.
When issuing options, be careful to work with your legal and tax advisors to ensure that all options are granted at the fair market value on the date the options are granted. Any stock option issued with an exercise price less than the fair market value on the date of grant will be subject to the non-qualified deferred compensation rules under Section 409A of the Internal Revenue Code. Since shares of private company common stock are not traded on an established securities market, the determination of their fair market value generally is made by the board of directors or by an independent valuation firm retained by the company. In our experience, the cost of an independent valuation is low compared to the time and resources expended if an investor, buyer or government agency later questions the fair market value determination. If a stock option is found to be subject to Section 409A, then the recipient would be required to recognize ordinary income as early as the year in which the option (or portion thereof) vests. This amount would also be subject to a 20% federal tax in addition to the federal income tax at the recipient’s usual marginal rate for ordinary income. Additional state income taxes may apply in some states.
Encourage employees to consult with legal and tax advisors to determine whether it is advisable to file a Section 83(b) election.
An 83(b) election is essentially a letter sent by an equity award recipient to the Internal Revenue Service (IRS) letting the IRS know the recipient would like to be taxed immediately on restricted property (such as shares of restricted stock) on the date the equity was granted rather than later as the equity vests. In the case of an early-stage company, the value of the transferred restricted property (such as restricted stock) could be relatively insignificant on the date of grant, but if the company does well and appreciates in value, the value of the transferred shares would likely be significantly higher as it vests. In certain cases, it may be beneficial to file an 83(b) election. However, we strongly discourage companies from advising recipients on whether or not to file an 83(b) election or assisting in the preparation of or actual filing of the election.
Series: Key Considerations for Emerging Companies
Early stage companies have particular legal needs. Our Emerging Companies Practice Group is releasing a monthly “Key Considerations” series, in which we will share our experience by outlining the most critical factors a company should consider in the most relevant subject areas. The first installment in our monthly series was released in March and focused on Formation and Structure. Keep an eye out for these monthly installments over the course of 2021.