These days, it’s commonplace for startups to offer equity to their employees. In fact, it’s an expectation when you join a company that’s small in size or has high growth potential. Employees know that getting in early with a startup can have a huge payoff and that’s due in large part to startup employee equity.
For some, it can be one of the reasons employees choose startups over more established companies. They want to feel ownership in the company and know that they could eventually reap the rewards of their hard work. With 54% of companies globally reporting talent shortages, many companies find that offering employees stock-based compensation with a vesting schedule can help with employee recruitment and retention.
So what exactly is employee equity and how does it work? We’ll break it down for you.
Employee equity is the practice of granting stock to employees as part of their compensation packages. The equity represents a percentage ownership in the company. As recently as 2014, 7.2% of all private sector employees (8.5 million people) and 13.1% of all employees of companies with stock held stock options, according to the National Center for Employee Ownership. If the value of this equity multiplies year-on-year as the company’s valuation grows, having a stake in the business can become a huge financial asset for the employee in the future. The theory behind this is that the employee will be more productive when they are invested in the company’s success.
At some point early on in a company’s life, generally before the first employees are hired, a number of shares will be reserved for an employee option pool (or employee pool). The option pool is part of a legal structure called an equity incentive plan. A typical size for the option pool is 20% of the stock of the company, but, especially for earlier stage companies, the option pool can be 10%, 15%, or other sizes. Once the company has created the employee equity pool, the company’s board of directors grants stock from the pool to employees as they join the company.
The exact size of the pool is determined by complex factors between founders and investors. Companies should reserve in the option pool only what they expect to use over the next 12 months or so; otherwise, given how equity grants are usually promised, they may be over-granting equity.
There are different types of stock. Two important classes of stock are common stock and preferred stock. In general, preferred stock has “rights, preferences, and privileges” that common stock does not have. Typically, investors get preferred stock, and founders and employees get common stock (or stock options). The exact number of classes of stock and the differences between them can vary company to company, and, in a startup, these can vary at each round of funding.
There are multiple ways employers may grant equity to their employees. First, a company can issue a restricted stock award. A restricted stock award is given to the employee as a form of compensation. The stock awarded has, as its name implies, additional conditions on it, including a vesting schedule. Restricted stock awards may also simply be called stock awards or stock grants. Typically, stock awards are limited to executives or very early hires, since once the value of the shares increases, the tax burden of receiving them (without paying the company for their value) can be too great for most people.
Usually, instead of restricted stock, an employee will get stock options. A stock option is a contract between two parties that gives the buyer the right to buy or sell underlying stocks at a predetermined price and within a predetermined time period. An employee who has received a stock option grant is not a shareholder until they exercise their option, which means purchasing some or all of their shares at the strike price. The strike price is the fixed price that the employee may purchase shares for as set forth in the stock option agreement. The key to stock options is in its name, it is an option. The employee is under no obligation to purchase the shares.
Vesting is the process of gaining full legal rights to something. In the context of compensation, founders, executives, and employees typically gain rights to their grant of equity incrementally over time, subject to restrictions and the predetermined vesting schedule. Vesting occurs incrementally over time. Companies may also implement a cliff. A cliff is a minimum amount of time that an employee must work for the company before they can vest. A very common vesting schedule is vesting over 4 years, with a 1 year cliff. This means you get 0% vesting for the first 12 months, 25% vesting at the 12th month, and 1/48th (2.08%) more vesting each month until the 48th month.
Options are only exercisable for a fixed period of time. The exercise window (or exercise period) is the period during which a person can buy shares at the strike price.
To help reduce the tax burden on stock options, a company may make it possible for option holders to early exercise (or forward exercise) their options, which means they can exercise even before they vest. The option holder becomes a stockholder sooner, after which the vesting applies to actual stock rather than options. This will have tax implications.
While stock options are the most common form of equity compensation in smaller private companies, Restricted stock units (RSUs) have become the most common type of equity award for public and large private companies. Facebook pioneered the use of RSUs as a private company to allow it to avoid having to register as a public company earlier.
RSUs refer to an agreement by a company to issue an employee shares of stock or the cash value of shares of stock on a future date. Each unit represents one share of stock or the cash value of one share of stock that the employee will receive in the future. These are called units because they are neither stock nor stock options.
RSUs are difficult in a startup or early stage company because when the RSUs vest, the value of the shares might be significant, and taxes will be owed on the receipt of the shares. This is not a bad result when the company has sufficient capital to help the employee make the tax payments, or the company is a public company that has put in place a program for selling shares to pay the taxes. This is why most startups prefer to use stock options.
The tax implications for employee equity are complicated because they are vastly different for restricted stock, stock options, and RSUs. Tax laws and regulations also differ between countries. These differences can create risk and unforeseen consequences. Common equity related tax and payroll challenges for employers with globally mobile employees include:
It is important for employers to review the individual plans and determine the appropriate tax treatment in the various countries. The DLA Piper has a helpful guide to global tax implications involving employee equity.
If you’re looking for support with building your equity program, Carta is a great resource. As the leading equity management solution, Carta works with private companies to help with certain valuation varietals, cap tables and reporting. It also offers tools and services for the venture class.
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