Hiring and keeping talented employees is a challenge for many businesses, but in particular for startups and early-stage companies that are more limited in the amount of cash flow they can commit to competitive salaries. One way to bridge this gap is with equity incentive compensation. Broadly speaking, equity incentive compensation refers to the grant by a company to its key employees and service providers of an ownership stake.
For startups positioned to realize significant potential growth in the value of their companies, this type of compensation can be especially appealing to employees and service providers who see the potential of “getting in on the ground floor”. But more than just luring top talent, equity incentive compensation can help any company achieve the following:
1. More strongly align the interests of, and incentivize high-level performance from, key employees or service providers;
2. Build employee loyalty and develop a more authentic sense of purpose; and
3. Save and redeploy early stage cash that would otherwise have to be spent on salaries or contract labor.
Types of Employee Equity Incentive Plans for Private Companies
Equity incentive compensation can take many forms for private companies, with each presenting a unique set of advantages and disadvantages. While the optimal types and structures for any given company will depend on its particular business circumstances, below is a summary highlighting some of the most popular kinds of equity incentives used by many private companies today.
Stock Options. Stock options are a well-known form of equity incentive compensation that can be utilized by corporations. The holder of a stock option has the right to buy stock of the company at a set price, called the “exercise price”, for a certain period of time (typically ten years) beginning when the stock option vests.
The exercise price usually is equal to the fair market value of the stock at the time the stock option is granted. Stock options almost always vest over time (typically 3-4 years) to help motivate the recipient to continue to be employed with the company longer term. The holder becomes an actual shareholder of the company only when the stock option is exercised and the stock underlying the option is purchased for the exercise price.
Stock options can be attractive to holders if the company expects substantial growth and/or a liquidity event (sale) down the road at an increased value. However, if there is no appreciation in the company’s stock over time, then the option provides the holder with no financial benefit. The holder of a stock option must also have the cash necessary to pay the exercise price to convert the options to actual shares of stock.
As a practical matter, stock options of a private company are almost always converted only at the time of some liquidity event, such as a sale of the company or an IPO, and then the exercise is “cashless” (meaning the exercise price is taken off the top of the proceeds the option holder would otherwise realize had he or she actually paid the cash exercise price, converted the options to shares, and then concurrently sold them at a profit as part of the liquidity event).
Restricted Stock. Restricted stock is an actual grant of shares of stock, but for a period of time (a “restricted period”) the shares (1) can typically be repurchased by the company for a set price, (2) are subject to forfeiture by the holder without payment upon the occurrence of certain events, such as when the holder’s services to the company terminate prior to vesting in full, and (3) are subject to restrictions on transfer or resale.
Because the holder will become a shareholder on the grant date, he or she will normally have the right to vote and receive dividends. Restricted stock can incentivize holders since they should theoretically become similarly aligned with the company’s other shareholders immediately upon the initial grant.
The holder isn’t required to pay anything (or only a minimal amount) at the time the stock is granted, and depending on the value of the stock at the time of grant, he or she may realize a substantial long-term tax benefit by making an IRS Section 83(b) tax election.
Profits Interests. Profits interests are the most common form of equity compensation used today by partnerships and limited liability companies. Profits interests are awarded to key employees and service providers in exchange for his or her contribution of services to the company (in lieu of being required to make a cash or other tangible capital investment as would be the case for a traditional equity investor).
A profits interest is technically an ownership interest that gives the holder the right to a share of future profits and appreciation of the company, but the holder is not entitled to participate in the capital and accumulated profits or value of the company as of the initial grant date.
For example, if the “hurdle” or “threshold” value of the profits interest holder’s participation was $3 million, it means the holder’s profits interest only begins to share in the company’s distributions or sale proceeds after the initial $3 million of value has been paid to its founders and/or cash equity investors. Please see our profits interest blog for additional information and key considerations around granting profits interests specifically.
Other. Other equity-based forms of incentive compensation include restricted stock units, stock appreciation rights, phantom stock, and long-term cash incentive plans.
A properly structured equity incentive compensation plan can help innovative companies stand out from their competitors when it comes to hiring and retaining key talent. However, various legal and business considerations, including important tax considerations, are critical when determining the best plan and structure for a particular company. Linden Law Partners has many years of experience counseling entrepreneurs and businesses on the intricacies of equity incentive compensation. Contact us here for help.