Equity

One of the most common ways for startups to attract talent without spending a ton in salaries upfront is to offer your employees some equity in the business. This will not only save you money at the time you need it most but also aligns your employees’ goals with yours more so than if they were merely collecting a paycheck. They know that their hard work will be rewarded in spades when their tiny piece of the pie grows larger and larger over time. Equity is the great compensation equalizer in startup companies—the bridge between an executive’s market value and the company’s cash constraints.

There are many types of equity—each of which have different characteristics:

• Restricted Shares. Restricted shares most often require that an executive remain with the company for a specified time period or forfeit the equity, thus creating “golden handcuffs” to promote long-term service. The executive otherwise enjoys all the rights of other shareholders, except for the right to sell any stock still subject to restriction.
• Stock Options. Stock options are another choice, and they generally come in two forms: incentive stock options (ISOs) and nonqualified stock options (NSOs). Most options, whether ISOs or NSOs, involve a vesting schedule. Executives may receive options on 1,000 shares of stock, but only 25% of the options vest (i.e., executives can exercise them) in any one year. If an executive leaves the company, he or she loses the unexercised options.
  • ISOs. ISOs can prove beneficial to employees because (1) regular federal income tax is not triggered upon exercise of ISOs (although the alternative minimum tax may be) and (2) qualifying dispositions of ISOs (selling your stock) enjoy long term capital gains treatment. In order to qualify for long term capital gains, the option must be exercised during your employment, and the shares issued upon exercise must be held for at least one year after the exercise date and at least two years from the date the option was originally granted. ISOs can only be granted to employees (not to advisors, consultants or other service providers).
  • NSOs. NSOs can be issued at a discount to current market value. They can be issued to directors and consultants (who cannot receive ISOs) as well as to company employees. And they have different tax consequences for the issuing company, which can deduct the spread between the exercise price and the market price of the shares when the options are exercised. NSOs can also play a role in deferred compensation programs. More and more startups are following the lead of larger companies by allowing executives to defer cash compensation with stock options. They grant NSOs at a below-market exercise price that reflects the amount of salary deferred. Unlike standard deferral plans, where cash is paid out on some unalterable future date (thus triggering automatic tax liabilities), the option approach gives executives control over when and how they will be taxed on their deferred salary. The company, meanwhile, can deduct the spread when its executives exercise their options.

“Equity is the great compensation equalizer in startup companies.” 

• Stock Appreciation Rights and Phantom Stock. These programs allow key employees to benefit from the company’s increasing value without transferring voting power to them. No shares actually trade hands; the company compensates its executives to reflect the appreciation of its stock. Many executives prefer these programs to outright equity ownership because they don’t have to invest their own money. They receive the financial benefits of owning stock without the risk of buying shares. In return, of course, they forfeit the rights and privileges of ownership. These programs can get complicated, however, and they require thorough accounting reviews. Reporting rules for artificial stock plans are very restrictive and sometimes create substantial charges against earnings.
  • Restricted Shares. Entitles employees to receive cash or stock in an amount equal to the excess of the fair market value of the company’s equity on the date of exercise over the exercise price, which is typically equal to the fair value of the company’s equity on the date of the grant. These provide employees with the same financial gain as would a comparable stock option, without requiring a cash outlay upon exercise. This provides an incentive to employees and serves to retain them. If settled in cash, SARs will not give up any control of the company.
  • Phantom Stock. Entitles employees to receive cash or stock in an amount equal to the value of an equivalent number shares of stock, or appreciation in value of an equivalent number of shares of stock since the date that the units were awarded, upon the occurrence of one or more predetermined events (ex. A change in control of the company, retirement at or after age 65, etc.). Similar to SARs, but realization of value is tied to the occurrence of an event, rather than the employee’s unilateral election.
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While there are many types of equity, whatever forms are used, you must be able to add equity into the compensation mix to not only bridge the gap from cash compensation deficiencies but to get everyone aligned to the same end game.