Equity Incentives: A Guide for Early Team Members
So you’ve set up your entity to make your dreams come true! Congratulations! But now you may need to figure out how to distribute ownership between you and your other team members as well as attract top talent to help build your dream company.
This post is focused more on the stereotypical “Startup” company. The company that starts with an idea (let’s say tech). The company that starts with just you and two team members. You know that you and your team need to have an ownership stake in the company, and you also know that to bring in talented employees, you need to give them some ownership as well, because your dream hasn’t generated enough revenue for competitive salaries and you haven’t raised capital yet. You also hope that your early hires will want a stake of your company’s success. Rather than focusing solely on the short-term benefits of a higher salary, you hope that these early hires will have an interest in the long-term success of the company as well and will embrace the fact that the company’s success results in a far greater pay day for them in the future.
So what does this look like? While there are several options for the exact structure of equity incentives, this post will discuss a simple equity grant and a few of the features that are common to grants to Founders and early team members. This post won’t tell you everything you need to know to draw up the documents and present them to a potential hire, but is meant to help you consider your options and present ideas with a little more detail.
So what do you do? This post is going to go through a common method of compensation for you and your friends as well as new team members. As always, there are many more options and details than we could put into a blog post, so if you’re interested in learning more, shoot over an email at Info@Trentwilliamslaw.com.
Founder Shares
For you and your friends, you will probably want to keep things fairly simple. An easy option for this is a simple Equity Grant or Stock Award or Founder Shares. These are all phrases that are used that essentially mean that shares of stock are given to an individual (and these will be Restricted Common Stock). And each grant/award/etc. will contain many terms/phrases/provisions that this post will unpack a bit.
Vesting
These shares often times have a “Vesting Period” - meaning that the individual does not actually own the shares until a point in the future. A common vesting schedule might be “4 years with a 2 year 50% cliff then monthly vesting”. But what does that mean? To break it down, this means that the owner of the equity will not actually own any interest in the company until 2 years from the grant. At that time, they will own 50% of the total shares granted to them. Then the remaining 50% would become their property proportionally over the course of the next two years.
A structure like this incentivizes founders or early employees to work for the company for at least two years, but also incentivizes continued work following the two-year cliff. In order to recognize the full benefit of their equity grant, an individual would need to work for the company for at least 4 years.
Now that we’ve covered the big picture, we’ll dive into a few other common terms and provisions and try to provide a little more clarity.
Par Value
So what do you have to pay for this ownership interest? You can’t just give away part of a company without getting something in return, right? How would we ever calculate taxes? In order to address this, companies will have a “Par Value” for their shares - this is the lowest price that a company can legally offer its shares to an individual. Common Par Value may be something like $.00001 for a brand new company. So you could own 1 million shares for as little as $10.00 (if this is a purchase agreement), or could have a very low tax burden for the shares that are issued in exchange for services (File an 83B and thank us later!). For companies that haven’t raised capital or really launched a high revenue-generating product or service, this is quite common. So as you are starting your company and choosing the best Par Value, don’t be afraid to choose something like $.00001. This doesn’t mean that your company is “worthless” and it won’t scare away anyone.
So let’s say this is an actual “grant” and not an option (a topic for another day). If an early team member is granted 1,000,000 shares of common stock with a $.00001 par value, then those shares are “valued” as $10.00 of income. With the proper elections/filings, this “income” would be taxed at the appropriate level. Then when your company sells for $10 billion, and your 1 million shares are worth far more than $10, you’re going to be a lot happier!
Transfers
Often times, these shares will prohibit transfers. This is done as insurance against a disgruntled member transferring or selling their shares to the highest bidder (maybe a competitor). So even after those shares have vested, it’s a smart idea to have those shares “restricted” as far as transfers. Many shares will only be transferrable with the approval of the Board or approval of the shareholders.
Buy Backs
A tag along to the transfer restrictions mentioned above is a standard buy-back provision. This would commonly provide the company with the right to buy back the shares from the holder at a designated price. Again, these provisions are all set up to protect the company, and if you’re the Founder, you’re going to want to make sure you have these built into your grants (even your own).
Acceleration
The last term we’ll discuss is acceleration. We’ve discussed how shares don’t actually become the team members property until they have vested. But what happens if the company is acquired prior to the vesting period ends? Or what if it’s acquired quickly before the two-year cliff has even occurred? This is where acceleration comes in, and there are two primary types.
Single Trigger Acceleration - this occurs upon a singular event. Maybe it is the sell of the company (most common). In the event that the ownership/control of the company changes hands, this might result in a full vesting of the shares. Meaning that once the company sells and generally upon a “change of control” the shares become 100% vested and become property of the holder.
Double Trigger Acceleration - this is the more common method, and it not only would require a change in ownership of change of control, but would also require that the individual be terminated or have his/her role or responsibilities or compensation negatively impacted as well (for example). Meaning that if the new owners retained the individual following the purchase, and continued to compensate the individual similarly, then the shares would not accelerate and would follow the original vesting schedule without agreed upon changes to the schedule.
Hopefully this post has shed a little bit of light for some of you. It’s not overly detailed and there are many options for compensation that are not discussed. The point of this is to let each of you know that you can (and should) give away part of your dream to others who can help you build and develop something great. You won’t be giving them a percentage of your dream on day 1 and losing it on day 2. There are always provisions that protect you against this scenario. So if you’re short on cash or a potential hire wants some stake in the game also, don’t think that they’re taking advantage of you when they ask for some equity. There are a lot of upsides to issuing equity to those early team members and co-founders, and Williams Law can be there to make sure that its done correctly so that you avoid those costly mistakes down the road.
If you’re enjoyed this post and you’d like to learn more, check out the Williams Law Startup Series that began with Entity Selection, or tune in for our next post where we’ll be discussing some of those documents that all companies need such as NDAs, MSAs, SOWs, ETC.
