How to Issue Equity to Employees in a Startup
Most startups operate with limited capital. To keep employees on board, equity can be used to compensate them as the business grows. However, it's important to understand how to issue equity to employees. You need to find a good balance of protecting your ownership while also rewarding employees who are adding value to your company.
Why Equity Compensation Needs to Be Handled Carefully
There are many reasons to be careful when offering equity. It will be hard to retain employees if compensation is lacking, but you still want to make sure you are being smart. It is always a good idea to have the option of buying back stock from employees that do not stay with you long term. You also need to know that all the tax, legal and accounting matters are handled properly so that there aren't any complications later.
The Different Types of Equity You Can Offer
Generally, companies issue stock options or equity to early employees. Providing equity to early employees is a great way to ensure that capital is spent on the marketing of the business. If your startup is past the early phase, stock options are another great way to give employees an incentive to stay with your business.
A compensation plan that is often beneficial to companies is restricted stocks. These are stocks that come with several conditions. This compensation is typically utilized by companies that are a little more established but can also be used by new startups. Restricted stocks are issued to employees in a way that protects owners. For example, employees may be prevented from selling stocks prematurely. Stocks may only be offered if certain performance conditions are met.
Questions to Ask Before Deciding on How to Award Equity
Before you decide on a way to compensate your employees with equity, there are many questions to think about. They are:
1. What is the Long-Term Vision of the Company?
Are you planning to grow the company as fast as possible and eventually get acquired by a bigger company? Are you planning to take the company public and go through with the IPO process? Do you prefer to grow the company organically, opting to keep it privately owned for as long as possible? You need to have a clear vision of how you want to proceed so that you can come up with an employee equity plan that's beneficial to both you and your employees.
2. How Old is the Company?
Was the company founded a month ago? Has it been operating for more than a year? This will determine how you issue equity to employees. While restricted stock options are often used by established companies, they are also a great choice for new companies. Because there are certain conditions that need to be met, they can be used to motivate employees to perform. On the other hand, established companies can get a competitive hiring advantage by simply offering regular stock options.
3. What's the Company's Valuation or Projected Valuation?
As your company grows, you'll want to make sure you acquire the best talent. In this case, restricted stock options may not be the most attractive compensation plan for employees. If the company is growing at a fast pace and is projected to reach a specific valuation, it will affect how you issue equity. It may be better to offer stock options rather than equity.
The Challenges You'll Face with Issuing Equity
Deciding to issue equity to employees isn't as simple as it sounds. There are a large number of challenges you'll have to deal with. Here are some examples:
1. If you think that you'll need an outside investor in the near future, you may have to deal with employees not wanting to sell their holdings. For example, if you think it's a great idea to use equity-based financing to get the cash you need to grow, you'll need to convince employees to sell their shares. If you can't do that, you'll have to give more of your ownership away than you may be happy with.
2. You have to make sure that you don't give away more equity than you'd like. There's a lot of thought you have to put into this, especially if you're projected for big growth or you need an outside investor. If compensation is lacking, you'll also have a hard time attracting the right employees.
3. The structure of a company can determine the complexity of how to compensate employees. For example, LLCs and LLPs make it harder to give employees equity in the company. In some cases, it may be beneficial to change the structure of your company to make it easier to offer equity.
4. The tax issues that come with issuing equity can get very complex. You have to look into how deductions work, how employees are taxed, how the law applies to you in your state, and more. You need to work with legal and tax professionals that understand all the small details.
To sum up, it's not easy to issue equity to employees. There are so many things you need to think about and challenges you need to deal with when giving equity to employees. The best way to make the right decisions is to hire a professional that has experience with both the business, financial, and legal aspects of offering equity.
That's where we come in. Calkins Law Firm has helped many startups create employee equity plans that are a win-win for both parties. Contact us today to schedule a free consultation.