How to Slice the Pie with Equity Incentives: A Guide for Business Owners and Executives
Company equity is a powerful tool for compensating employees, attracting investors, and aligning the interests of key stakeholders with the long-term goals of the business. It is also a complex area that requires careful planning and consideration to avoid common pitfalls. Founders should consider the equity as a resource that dilutes existing ownership and look at the long-term implications of their decisions to allocate equity. In other words, how does an owner allocate a piece of the pie?
Understanding Equity Compensation
Equity compensation involves granting ownership interests in the company to employees, executives, or investors. This can take various forms, including stock options, restricted stock, restricted stock units (RSUs), and profits interests. Each type of equity has its own legal and tax implications, and the choice of equity type should align with the company's corporate structure and strategic goals.
Common Mistakes in Equity Compensation
Failure to Document Promises: One of the most significant mistakes is making informal promises of equity without properly granting or documenting the awards. This can lead to unmet expectations and legal disputes. It is crucial to properly authorize equity grants and formalize them through written agreements and ensure that all terms are clearly defined.
Inadequate Planning for Equity Structure: The type of equity offered should be carefully planned based on the company's corporate form (e.g., corporation, partnership, LLC) and the desired outcomes. Factors such as dilution, voting rights, and tax treatment must be considered. For more information on common mistakes with equity incentive design, please read our insight article on Equity Incentives: Common Mistakes. Phantom equity arrangements can be used to provide value without actual ownership, but they come with their own complexities, primarily tax planning for compliance with Section 409A of the Internal Revenue Code.
Lack of Buyout Provisions: Equity awards for private companies often include provisions for repurchasing shares in case of termination or other changes in the employment relationship. This helps manage liquidity issues and prevents disputes over the value of the equity.
Giving Away Too Much Too Soon. Sometimes, with optimistic exuberance, Company founders promise a large portion of equity to early stage employees, whose contributions are immediate but fading. Later state investors look at equity held by former employees and non-productive founders as “dead equity”, which affects Company valuations. If the grant terms had contained a Company buyout provision, as described above, there would be a path towards removing the equity from the cap table and solving this problem.
Strategic Considerations for Equity Compensation
How Much Equity to Give: There is no magic amount. That being said, trends and industry practices can provide guidelines for aligning the equity strategy with the marketplace, and an employee total pool comprising 10% to 15% is often described as a rule of thumb. The pool typically reserves a significant percentage to the Chief Executive Officer and tiered incentives for the top executive team or producers. If the Chief Executive is also a Founder and owns significant capital already, then typically there are not additional CEO equity grants until the Company is much more mature. It is important to pay attention to the burn rate to ensure that too much equity is not granted at the beginning as equity is needed for recruiting key personnel and new issuances create dilution.
Aligning Equity with Business Goals: The equity strategy should follow the company's overall strategy. For example, if the company plans to exit within five years, the equity structure should support this goal. This sometimes means a vesting schedule that aligns with an exit event or penalties for early management departures. Conversely, if the company is intended to be a family business for generations, a different equity structure may be needed. Employees of closely-held companies with no clear exit path are looking to build wealth, but they are also looking for liquidity opportunities, sometimes resolved with Company-sponsored equity repurchase windows.
Retention and Incentivization: Equity can act as a powerful retention tool by providing long-term rewards. If the employees understand their vesting and forfeiture schedules, it can create significant incentives for them to stay and pose challenges for competitors trying to hire them away.. It is important to communicate clearly with employees about the terms of their equity awards and manage their expectations. Some employers are hesitant to communicate the value of the past stock awards, which can cause employees to undervalue their awards while others are boastful about the stock value, which can interfere with third party fundraising efforts.
Valuation and Tax Implications: The valuation of equity awards and their tax treatment are critical considerations. Different types of equity have different requirements for valuation and tax reporting. For example, stock options are taxed on the spread at the time of exercise, while restricted stock may involve an 83(b) election to include the value in income at the time of grant in order to access capital gains tax treatment.
Don’t Keep QSBS Treatment a Best-Kept Secret. If an early stage employee or founder’s stock grants will qualify for treatment as Qualified Small Business Stock (QSBS), then upon sale, up to $15 million of gains can be shielded from tax entirely.
The Importance of Professional Guidance Before Promising Equity Awards
Navigating the complexities of equity compensation requires expertise in legal and financial matters. Engaging an experienced advisor or employee benefits lawyer can provide invaluable guidance in structuring equity awards, ensuring compliance with regulations, and addressing tax implications. A professional can help you avoid common pitfalls, draft clear agreements, and develop a strategy that aligns with your business goals. Their expertise can also assist in managing disputes and ensuring that your equity compensation plan is both effective and legally sound.
Equity compensation must be accounted for in the company's financial statements and reported for tax purposes. This includes providing employees with the necessary tax documents, such as W-2s for ordinary income or K-1s for partnership interests. An offer and sale of Company stock generally must be registered with the Securities and Exchange Commission, or qualify for exemption from registration, so of course it is important to properly comply with federal and state securities laws. Failure to address securities law, accounting and tax issues can be very costly to a company and its founders at the time of a later round of investment or at a liquidity event.
Effectively Allocating the Pie
Using company equity effectively requires careful planning, clear documentation, and strategic alignment with the company's goals. By avoiding common mistakes and considering the legal and tax implications, business owners and executives can leverage equity to attract and retain top talent, incentivize performance, and drive long-term success. Engaging a professional advisor or lawyer can provide the necessary expertise to navigate this complex area and ensure that your equity compensation plan is both effective and compliant.
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