Why should you offer equity as part of employee compensation? What are the benefits of equity vs. other forms of compensation?

Offering equity as part of employee compensation fosters a sense of ownership and maximizes effort – equity compensation is unique to fast-growing companies, particularly those backed by venture capital or private equity—and it can maximize the effort you get from employees. When employees feel ownership and get to share in the broader results, they are more likely to be motivated and do whatever it takes to move the company forward.

Equity aligns employee incentives with company growth – rather than just working for a paycheck and doing the bare minimum, employees who are offered equity are incentivized to work towards growing the value of the business. The more you foster this type of behavior, the more you will get out of all your employees.

Setting up the plan

What are the different types of equity compensation you can offer? What are the pros and cons of each?

There are lots of carve outs and qualifications when it comes to equity offerings – it’s a complex landscape and there are a lot of exceptions and contingencies that need to be accounted for when considering which equity offerings are best for your company.

How do you decide which employees should receive equity compensation?

Market rates and company strategy influence equity distribution – the company’s strategy and market rates significantly influence equity distribution. There are tools available that provide market data, helping companies understand the average compensation for various roles in different locations. Once the market data is available, it can be used in conjunction with the company’s budget to decide on equity distribution.

Benchmark your equity compensation against similar companies – companies can benchmark against similar companies in terms of capital raised and number of employees to have a more structured approach to employee compensation in both cash and equity. 

What are good standards for vesting timelines and cliffs?

At the early stage, the vesting schedule is almost always four years with a 25% cliff – this means that employees don’t receive any equity until they’ve been with the company for at least a year, and then more equity vests monthly for the next three years. This is the most popular vesting schedule for startups.

You may shorten your vesting schedules if you have limited equity, or company valuation is taking a hit – if you have limited equity, you might give out fewer shares but they would vest over a shorter period of time. In a down market, companies may opt for a vesting cycle of three or even two years to incentivize employees to stay. Some companies may even offer annual grants, giving out less equity but allowing employees to vest sooner. 

As companies move towards RSUs, they transition to a quarterly vesting schedule – this change aligns with the company’s growth and the increased value of the equity being granted.

Avoid out-of-the-box or complex vesting schedules – while companies have the flexibility to design unique vesting schedules, stick to standard norms, especially for early-stage companies. Deviating from the norm can introduce trade-offs and complexities that may not be known and end up detrimental in the long run. For instance, backloading equity to the fourth year might deter employees who don’t want to wait that long for their payoff. Complexity also adds to the burden of managing your equity plan. 

How big should your employee equity pool be?

Generally, 15-20% of overall authorized share capital is allocated to employee equity – once you introduce the equity incentive plan, it’s usually 20% of the overall authorized shares. As you give it out over time, the unissued amount goes down and usually it gets down to a few percent before needing to ask the board for an increase to account for more future hires. That dilutes everyone’s shares but it’s not something you need to regularly do for private companies. In other words the 20% includes both what’s issued and unissued.

When your share pool is dwindling, it may be time to transition to RSUs – this is a common practice and it’s a sign of a maturing company. RSUs have inherent value, as they are actual shares that you’re giving to your employees. Even if the stock market goes down, the shares could potentially go up in value. Typically, the ratio of options to RSUs is 3:1. So if you were to give employees 900 stock options, you would only need to give about 300 RSUs.  RSUs have inherent value, whereas stock options could potentially be worthless if the stock does not increase in value.

It’s a good idea to consult with a financial advisor or equity expert – remember, these are general guidelines and may not apply to every company. It’s always helpful to get expert advice.

How do you decide how much equity compensation employees at each level receive? How does the amount of equity you grant to each employee change as the company matures?

A few factors play into how much equity compensation each employee gets: 

• Their function – even though all functions may get equity, not all functions receive equal allocations. Oftentimes, technical roles receive more equity than others.
• Their level – executive leaders often end up with the majority of equity. 
• Negotiations – sometimes equity distribution comes down to how negotiations play out and what works best for your company to attract talent while preserving equity. 

Full-time employees are the primary recipients of equity – board members who are inventors don’t receive equity, but independent board members and advisors will often receive some form of equity (though not a significant amount). Contractors can receive equity, but it’s uncommon and there needs to be a compelling reason for it. If you do give equity to contractors, it’s usually non-qualified options or, less commonly, RSUs.

The lion’s share of the equity tends to go to executives – as your company matures and establishes itself, you may find that you have less equity in your share pool to distribute. This is a natural progression and is not necessarily indicative of any issues within your company.

What important terms or requirements should you write into equity compensation to protect your company? 

Work with outside legal counsel to write smart terms – when creating your equity incentive plan, it’s advisable to work with outside legal counsel. They can help you navigate the standard clauses and nuances that should be included in your plan. 

Don’t try to get fancy when you’re starting out – while there are many changes you can make to your equity incentive plan, some companies may be tempted to get fancy with their equity incentive plans. However, this can often lead to administrative headaches. It’s best to keep things simple and stick to the most common practices. 

Terms to consider when setting up an equity incentive plan, including:

• Termination definitions 
• What happens to equity when people leave
• Early exercise ability for early employees
• Change in control language
• Cause definitions
• Provisions for people on leave

Should employees always have common shares?

Employees typically get common shares – in most cases, employees are given common shares in a company. This is a standard practice across almost all businesses, sizes and industries.

Preferred shares are typically reserved for investors and come with additional benefits – these benefits may include preference in the event of a liquidation or additional dividends. However, these are typically reserved for investors because they put up a significant amount of money and take on a large amount of risk.

Administering Your Plan

What tools can you leverage to effectively administer your employee equity plan?

Data providers offer information on equity compensation – such as Pave, Radford, and Mercer. These providers primarily cater to public and large companies, and their data may not always be relevant for smaller, early-stage companies. 

Pave has particularly comprehensive and up-to-date data – Pave has data from almost 7,000 companies, primarily private ones (especially among VC and PE-backed tech companies). This allows you to compare your company to similar ones and get relevant market data. Unlike other providers that rely on annual surveys, Pave collects data through integrations with HR and cap table systems. This means the data is constantly updated, providing a real-time pulse of the market—in volatile compensation markets, data recency is crucial.

How do you effectively communicate your equity compensation plan to your employees? 

Educate employees on the basics of stock options – companies that excel in this area spend a significant amount of time educating their employees on the basics of a stock option. This is crucial because if employees don’t understand the basics of equity, they won’t value it and consequently, won’t be motivated to give their 110% best performance. 

Regularly refresh employees on the information – successful companies also ensure that they regularly refresh their employees’ knowledge about their equity plan. Whether this is done through technology, videos, PDFs, or one-on-one sessions, it’s important that employees understand their equity plan and its value. Companies that fail to communicate regularly often see their employees leave. 

If you’re going to have a liquidity event or do a reprice, get in front of employees – any event that can have an impact on their equity should be accompanied by an information session for the employees. 

Employees can self-serve information through an equity management tool – employees often log into their equity platform and see their stock options. These platforms often have calculators that can show employees how much their equity could be worth if the company does well, and what their tax obligations would be. Leveraging these tools can be a great way to educate employees.

Set up a financial advisor for your organization to meet with – companies can also set up meetings with financial advisors to help employees understand their stock options and alleviate any stress they may have about their financial wellness. These sessions can be set up on a one-on-one basis, allowing employees to discuss their individual situations.

How should you leverage your equity plan when looking to attract new employees, board members, or executive talent? 

Equity is a key differentiating factor in recruitment – especially in startups, equity can be a significant draw for prospective employees compared to the cash compensation of public companies. 

Understanding the value of the company and the potential value of equity is crucial – knowing the company’s most recent valuation, the preferred company valuation price, and the potential worth of the equity being offered can be a powerful recruitment tool. 

Equity can be a life-changing amount – for those joining a startup, the vision is to grow exponentially. The potential worth of the equity offered could be life-changing, making it a compelling reason to join the company.

Don’t shy away from the equity conversation – it’s important to be transparent about the company’s valuation, the stock price, and the potential value of the equity. This honesty can be a powerful motivator for prospective employees.

No one is making a promise – while discussing the potential growth of the company and the potential value of the equity, it’s important to remember that these are not promises or legal obligations. They are projections of where the company hopes to go.

Who should be responsible for equity administration?

Legal Counsel handles initial stages – when you’re just starting out with a few people on the cap table, it’s manageable to do it in Excel. But in the early stages of your business, your legal counsel will typically manage your cap table. This is often done through an equity management tool they license and use for you. It can be a costly process. 

Eventually transition it to a Finance employee – as your business grows and you start giving equity awards on a broader basis, the responsibility usually shifts to someone in finance, often a controller. This transition involves moving from the law firm’s system to your own, where you’ll have access to the same database but will need to fill it out with more detailed information, such as home addresses for tax purposes.

HR may eventually take over as you approach an IPO – in some cases, the responsibility for managing the equity plan may be transferred to someone in HR. This is particularly likely as you approach an IPO.

Have a designated stock plan administrator pre-IPO – this person acts as a liaison between finance, legal, and HR, as equity touches all three groups. This isn’t usually a full-time job until you reach the pre-IPO or public stage, when more reporting is required for the equity.

Some firms outsource administration to ensure they do it correctly – since managing an equity plan isn’t always a full-time role but is very important, you might consider outsourcing the administration to an outside firm. This ensures that the job is done correctly without needing to dedicate an employee to equity full-time.

What are the major equity administration activities? 

Administration to handle cap table development and maintenance, including: 

• New employees and awards – this involves understanding who is receiving equity and ensuring the equity is granted appropriately— issuing notice of grant and grant agreements to participants and updating the database with new grants.
• Ensure equity award acceptance – it may require additional communication and follow-up to ensure all awards are accepted and recorded correctly.
• Managing terminations or exits – as employees leave the organization, it’s important to record terminations accurately. This includes entering employee terminations, tracking post-termination exercise periods, and providing termination statements for employees.
• Record stock-based compensation for accounting purposes – this involves understanding and applying accounting rules and guidelines to value and record the expense of equity. This process may start as an annual undertaking, but can become more frequent as the company grows.
• Handling repurchases – this can include situations where an employee has left the company and a portion of their award needs to be repurchased due to forfeiture.
• Managing modifications of awards – when an award is modified—for example, extending an employee’s ability to exercise their award. Any modifications can result in additional expenses that need to be recorded to account for the extra value given.

Helping with equity reporting, compliance, and strategy:

• Supporting the tax-withholding process – this needs to be done for equity transactions such as RSU releases and NQ stock exercises in conjunction with the payroll department.
• Reviewing equity compensation strategy – companies should review their equity compensation annually to ensure it aligns with their goals and stage of growth. As a company gets more mature and the risk of joining is less, grant amounts generally get smaller.
• Option pool tracking against your equity forecast – evaluate your option pool against your equity forecast.

Throughout the year, there will always be unique and edge cases – this can include special arrangements for specific employees or changes in grant loading schedules. These tasks require constant attention and management to ensure all aspects of administration are handled correctly.

What major company milestones or events impact your equity administration? 

Major milestones or events include:

• Liquidity events – these are significant occurrences that require a lot of coordination. For instance, if your company decides to do a tender offer, it’s a substantial undertaking that needs careful planning and execution.
• Repricing – this is a common practice when company valuations go down. The company can decide to reprice their options for all existing employees. For example, if the strike price was set at $5, the company can decide to lower it to $2. 
• Going public – you have to convert your shares to be able to sell them on the open market. It’s a complex process that requires careful planning and execution.
• Stock split – when your stock price reaches a certain dollar amount, or if you’re trying to reach a target right before your IPO, you might split your stock and have to adjust your employee equity.
• Major layoffs or executive leaves – if a large group of people are leaving the organization all at once, it’s a flood of equity administration. You might need to accelerate awards and cash out employees who are leaving. 

What are the tax reporting requirements for equity plans? How can you comply with them?

It’s important to remember equity compensation is not free – equity compensation comes with a cost to the company. For tax purposes, you must figure out how much stock-based expense you need to record regularly. This expense could be broken down by department, a task that most systems can handle if used correctly.

You have to record cash received from stock option exercise – when employees exercise their stock options, the cash they pay to the company goes into the additional paid-in capital. Understanding where all this goes on the books is vital.

There are several tax forms for stock option exercise to be aware of:

• Form 3921 for ISO compensation – The company must produce this form and deliver it to employees, usually by the end of January. It’s crucial for companies to ensure they’re on top of giving this out to avoid tax penalties for late delivery.    
• Form W-2 for non-qualified stock options & RSUs – the income from non-qualified options and RSUs is simply recorded in payroll systems and gets added to this form as taxable income.
• Form 1099 NEC for equity given to non-FTEs– anyone who exercises their options throughout the year and isn’t an FTE will require this form for tax reporting.
• Form 3922 for public companies with ESPP purchases – if your company is public, and people are making Employee Stock Purchase Plan (ESPP) purchases, there are 3922 tax forms. If people are selling those shares, there will be some 1099 forms for those sales. In these instances, the broker is responsible for the tax reporting, making it a bit easier for the company.

How do you properly report on equity compensation for the purpose of audits?

Build a central source of truth – one of the main benefits of having a system like Carta in place is the ability to always get a point-in-time, central source of truth. This allows you to accurately track and monitor your company’s progress and status.

Create a view into historical data and future projections – a well-implemented system allows you to go back historically and to look into the future. Whether you need to review the cap table from last year or three months ago, you can easily access all the details up to that specific point in time. If you’re planning a tender offer, you can input rules and determine who will be vested at a certain date, who’s been with the company for more than two years, etc. This allows you to identify the population of eligible shares or grants for the tender offer.

A good cap table management tool eases the financial reporting burden – you’ll use the tool to denote all the activity and stock-based compensation recorded as of a specific date. This ensures accuracy and consistency in your financial reports.

What is the role of equity management in corporate governance, particularly in terms of voting rights and control?

Use your administration tool to keep track of voting rights – when loading different stock designations into the system, it is essential to indicate which ones have voting rights. The quality of the data you input determines the quality of the reporting, so if you load shares without specifying voting rights, the reports won’t reflect them. The cap table report should provide a straightforward summary of who can vote and who cannot. 

It falls on the administrator to ensure governance aspects of equity are recorded  – the responsibility of loading the equity and ensuring all additional details are included falls on the administrator. The system will handle most of the work, but it is crucial to ensure all details are included. 

Overall

What are the most important things to get right? 

Ensure correct plan documents are loaded into the system – these are legal documents that employees will accept electronically. It’s crucial to give the correct template to each employee. If you accidentally give an employee a grant template that includes additional vesting acceleration in the event of a change in control, that’s what they’re legally accepting, even if it was not your intention. Mistakes like these can have significant financial implications for the company. 

Distribute the right amount to the right employees – not only at the point of hiring, but at the moment of the grant. Ensure the right employees receive the correct documents. This can be particularly challenging in companies with employees who share the same name. To avoid confusion, use unique employee ID numbers that match up with the HR system. 

Attention to detail – it’s essential to accurately record the board’s intentions in the system. This includes ensuring that the correct number of shares goes to the right person. Attention to detail in equity plan setup and administration can prevent costly errors and misunderstandings.

What are common pitfalls?

Laziness in keeping data updated – while data management might not seem like a top priority, it’s extremely important and can lead to serious issues. Without regular updates, data can become outdated and inaccurate. This can lead to problems such as terminated employees receiving new grants or employees exercising more shares than they should have. 

Forgetting to log terminations – when an employee is terminated, it’s a difficult time for everyone involved. However, it’s important to remember that the employee is still a shareholder and potentially has access to certain privileges for your company. Therefore, it’s crucial to handle terminations with care and ensure that all data related to the termination is updated promptly.