Start-ups routinely offer equity compensation to their initial employees. This can be a mutually beneficial arrangement. Employees who own a stake in the company can reap lucrative financial rewards as the business grows and profits. This serves as an incentive for workers to invest themselves personally in the company. Meanwhile, founders can save cash by substituting equity, all while recruiting top talent.
But equity compensation can be a double-edged sword. There’s a correct way to go about the process, and there are potential legal issues involved. If equity compensation fits your business model, talk to the New York business law attorneys of Rosenbaum & Taylor. Reach out to us for a free consultation.
What Procedure Should You Follow When Offering Equity Pay?
These are a few basic steps to properly implement a plan for granting equity to new hires.
Create an ESOP (Employee Stock Option Pool)
You should set aside around 10-15% of your company’s equity for your Employee Stock Option Pool, or ESOP. This equity will be reserved for your future employees. As you distribute the equity, the pool will diminish. But you can increase the percentage of equity that is designated for the pool.
Select the Type of Equity You Wish to Offer
Most startups typically grant one of three types of equity to employees.
- Stock options. These give employees the right to buy and sell shares from the founders at a preset price. This right is exercised sometime between the vesting and the expiration dates.
- Stock warrants. A stock warrant is the right to buy and sell shares from the company (not founders) at a predetermined price. Warrants can only be exercised between the vesting and expiration dates. However, they typically have longer expiration dates than stock options.
- Stock grants. These give employees ownership of a set amount of stock. An employee can sell his or her shares immediately because there is no vesting or expiration date.
Choose the Vesting Period
If vesting is relevant to your plan, determine what period it will be. A four-year vesting period is common for equity compensation. The employees would earn 25% of their stock each year. You should also impose a cliff period, generally at least a year. This is the minimum amount of time an employee must stay with the business before vesting starts.
Determine the Amount of Equity to Grant Each Employee
There are different ways to do this. One company might choose to grant equity in an amount based on an employee’s seniority in the company. Meanwhile, another start-up may extend equity equally to all its workers. In most cases, the first employees usually receive more equity than those who later join.
Use a Capitalization (Cap) Table to Document Employee Equity
You need a written record of everyone who is a shareholder of your company, including employees, advisers, and investors. This is the purpose of a cap or capitalization table.
It should detail the total number of stock options already exercised. It should also document the total number of shares that are still available in the option pool. The company should regularly update this document to ensure it accurately reflects the company’s ownership.
Legal Considerations With Equity Compensation
Offering equity to employees may sound relatively straightforward. However, an equity compensation plan can quickly get complicated if the business founders don’t run it properly. These are some issues you should know about.
- A 409A valuation must be conducted to determine the equity’s fair market value to ensure employees are fairly compensated.
- Securities regulations like Rule 701, “no sale” requirements, and Section 4(2) or Regulation D govern equity issuance.
- Equity compensation has tax consequences (e.g. income tax and capital gains tax) that can affect its value.
- Corporate laws, state and federal, can create significant regulatory hurdles that companies must prepare for.
Let Rosenbaum & Taylor Handle the Legal Aspects of Your Startup
The legal implications of an employee equity compensation plan can be numerous. You need an experienced law firm dedicated to handling every legal matter involved with your start-up. To learn more about instituting an equity compensation plan, contact our New York business attorneys today.