A startup is an organization designed to search for a scalable business model. That is, the original founders are taking a shot at creating something that can one day become very profitable – but it’s not always clear how they’ll do that. As such, startups tend to be high-risk ventures with lots of unknowns. This is why it’s crucial that founders know the 6 most important things about startup employee equity.
1. Types Of Equity
Startup employee equity comes in two varieties: restricted stock and options. In the early stages of a startup, some founders explain the two varieties to their employees and ask them to fill engagement surveys online based on that. This can help in making a decision, but of course, some founders prefer to do that on their own. Restricted stock is when the startup gives employees shares of company-issued common stock, which can be purchased at a fixed price for a specific period of time. Options are rights to buy a share in the future – this right, however, is not transferable and is only good as long as the option is valid. There are two types of options: incentive and non-qualified. Incentive options have more favorable tax treatment than non-qualified options, so this type of startup equity should be considered by founders.
2. Cashing Out And Vesting
Startup employee equity is well-suited to those employees who plan to work for the company long-term. There is a risk that these dedicated employees could someday cash out their shares, but you could put a clause in the contract that they have to offer their shares to the company first at a fair market price if they do decide to sell. Another thing founders need to know is that some startup employee equity can be subject to vesting schedules. Vesting is when recipients of equity grants receive their shares over time. In other words, vesting means that founders can incentivize employees to stay with the company long-term by awarding them shares over time – the more they stay the higher their equity stake becomes. A vesting period can be beneficial because it ensures that employees stay and work for the company long enough to help it grow. It can also be used to reward employees. Typically, the equity structure is a four-year vesting period, which means they earn 25% of their stock each year.
3. Employee Stock Options Pool
The number of shares for an employee stock option pool is a set amount that only the board of directors can adjust. If a founder is considering increasing this pool, they should make sure that it doesn’t dilute their ownership percentage – otherwise, they’ll be losing power and influence over the company as more common stock will now exist. The options can also have terms that are more favorable to the employees. This is another reason why founders need to have a good partnership with their investors. Stock warrants can be used to increase the size of an employee stock option pool. However, these warrants must be exercised within a certain time period and cannot remain outstanding indefinitely.
4. Stock Grants
A founder might choose to give their employees stock grants instead of restricted stock or options. This type of equity can be transferred and doesn’t have a vesting schedule. Startup employee equity should always come with a grant agreement that includes the number of shares, purchase price, and other important data. The risk with startup employee equity is that recipients of stock can cash them in for money. Since there are no time limits on when the shares need to be bought or sold, employees could wait until the company has increased in value before cashing them out.
5. Cap Table
A cap table is a record of all the shareholders of your company, including any employees, advisers, or investors who have equity. The number of shares issued (and what they’re worth) will fluctuate over time as new rounds of funding occur. Founders need to keep their cap tables up-to-date, so it always reflects the current owner of the company and all outstanding stock options. This document is an important tool in figuring out when shares can vest or if a new employee needs to be issued additional stock options. It should include the number of shares that have already been exercised and the number of shares still available in the employee stock option pool.
6. Dilution
Founders should remember that every time they raise capital, there will be a number of investors who will receive common stock in exchange for their investment. This means that the total percentage each founder owns could decrease over time. Founders need to keep this in mind when creating employee contracts because if employees are receiving equity directly from outside sources, they might be entitled to more of the company than what was previously agreed upon. To avoid these issues, founders should always work with their lawyers when hiring employees.
To make things simpler – a startup can increase the amount of equity assigned to the pool in different ways. One option is to dilute the shares of stakeholders. For example, if you have 10 X, and 9 employees plus the founder – everyone (including you as the founder) gets one X. 10 X is the entire startup in this case. However, if you want to pay additional employees in equity too, you might need to turn your 1 X into 0.5 X – which means everyone now gets 0.5 X (because 10/20 = .5). This is a good option if the startup is doing well – 0.02 X can be worth more than 2 X was worth at one point. However, doing this does have its risks if not properly monitored.
Startup employee equity can be a great way to conserve company resources and attract top talent, but it’s also something founders need to carefully consider and negotiate. Founders need to make sure they understand the guidelines surrounding their equity structure and how it can affect them before creating contracts. As a startup grows and develops, it’s important that the founders and original shareholders know that they are protected. Only with a thorough understanding of these guidelines will founders be able to attract top talent and ensure their startup’s success.
