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Equity 101 — Definitions, Distribution Methods, and Potential Issues.

Equity 101 — Definitions, Distribution Methods, and Potential Issues. Dividing up equity is no simple task. Before you decide on how to allocate equity, its important to have a deep understanding of the dynamics and methods to distribute it. I have cited all of my sources at the bottom of the blog post. The author of this article is Andrew Nakkache, co-founder and CEO of Gizmo.com and founder of the company.com.com. He has written a series of articles about how to distribute equity.
Andrew Nakkache Hacker Noon profile picture

Andrew Nakkache

Co-founder and CEO

Dividing up equity is no simple task. Before you decide on how to allocate equity, its important to have a deep understanding of the dynamics and methods to distribute it. Too many founders botch this in the beginning and have their equity granted to them before an MVP even makes it to market. Only to be left with headaches and a messy cap-table. I was lucky to have a couple of awesome mentors, help me along the way. Special thanks to Rick Nucci of Guru, in particular.

This blog post consists of mostly definitions. Dividing up equity is another blog, for another day. I have cited all of my sources at the bottom. Enjoy!

Stock Options Overview

Description: Grants employees the right to purchase equity (stock) in the company at a predetermined exercise price during a set time period in the future

Benefits: Provides an incentive for employees because options allow them to benefit from the increase in value of the company. Also provides some liquidity to the company upon exercise.

A stock option is a right to buy stock in the future at a fixed price (i.e., the fair market value of the stock on the grant date). Stock options are generally subject to satisfaction of vesting conditions, such as continued employment and/or achievement of performance goals, before they may be exercised.

Known as the employee pool or option pool — is the amount of the company that is reserved for future issuance to employees

  • A large option pool will make it less likely that a company will run out of available options.
  • The size of the pool is taken into account in the valuation of the company
  • Larger the pool; the lower the pre-money valuation, larger the post money valuation

Types of Stock Options

a.) Warrant

  • the right for an investor to purchase a certain number of shares at a predefined price for a certain number of years

b.) Restricted Stock Units (RSU’s)

  • Description: A grant of stock, which may be subject to forfeiture if certain future conditions
  • Benefits: Provides an incentive for employees, and helps to retain employees if goals are not met (ex.; continued accompanied by a forfeiture employment for a period of provision. Time or achievement of certain performance goals such as users, revenue, or net income)

c.) Equity Bonuses

  • Description: Performance bonuses paid in the form of equity instead of cash
  • Benefits: Provides an incentive for employees to meet performance goals while minimizing cash outlays by the company

d.) Stock Purchase Plans

  • Description: Permits employees to purchase equity in the company at a discount to fair market value
  • Benefits: Provides an incentive for employees by allowing them to participate in the growth of the company, while providing the company with some liquidity

e.) Stock Appreciation Rights (SARs)

  • Description: 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.
  • Benefits: Provides employees with the same financial gain as would a comparable stock option, without requiring a cash outlay upon exercise. Thus provides an incentive to employees and serves to retain them. If settled in cash, SARs will not give up any control of the company

f.) Phantom Stock Units

  • Description: 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.)
  • Benefits: Similar to SARs, but realization of value is tied to the occurrence of an event, rather than the employee’s unilateral election

g.) Refresher Grants

  • Description: These are “forward-dated grants” — i.e., you can give a high-performing employee a refresher grant today where 1/3 of it starts vesting immediately and the other 2/3 starts vesting when their initial grant is fully vested. This guarantees them a low-strike price and presumably a relatively large grant in a few years.
  • Benefits: For a company using options, it’s nice to grant employees options early while the strike is low. Helps to motivate EEs for the long-haul, without giving all of the equity up-front.
  • I’ve read Dustin Moskovitz at Asana does something like this, and I think it makes a lot of sense.

Equity Compensation Distribution Models

By offering Equity Compensation. A private company:

  1. Provides an incentive for employees to perform in the best interest of the company
  2. Preserves capital by paying lower cash compensation
  3. Can compete for talent with larger companies by holding out the prospect of significant appreciation in the value of equity

A.) Vesting — 2 types (well 2 main types)

1.) Performance Vesting- conditions that require the recipient to accomplish certain business objectives

  • Performance conditions can have a variety of targets, such as to increase revenue, reduce costs, or develop new products

2.) Service Vesting- Stock and options will vest over 4 years

  • 25% to vest at the end of the first year; with the remaining 75% vesting on a monthly basis over the next 3 years

Some companies choose to do back-weighted service vesting. For example, Snap Chat has their equity vest 10%, 20%, 30%, and 40% over 4 years, respectively. There’s some controversy over this structure, and can cause some animosity within a company if you’re not careful.

Unvested Stock — typically disappears when someone leaves the company

  • Equity doesn’t get reallocated; rather it gets absorbed and everyone (VCs, stockholders, option holders) will benefit ratably from the increase in ownership — AKA Reverse Dilution

Unvested Employee Options — goes back into the option pool to be reissued to future employees

Major Component of Vesting — Defining what (if anything) happens to vesting schedules upon a merger or acquisition

  • Single-trigger acceleration refers to the automatic accelerated vesting upon a merger
  • Double-trigger acceleration- refers to two events needing to take place before accelerated vesting can occur
  • Specifically, an acquisition of YourCO combined with the employee in question being fired by the acquiring company.
  • In VC funded deals — a double trigger is standard opposed to single trigger

Recommendation - use a balanced approach to acceleration, such as a double trigger with one-year acceleration and recognize that this will often be negotiated during an acquisition.

Vesting works for the founders and the VCs

  • By vesting each founder, there is a clear incentive to work your hardest and participate constructively to the team day in and day out.
  • Same rule applies to employees; since equity is another form of compensation, vesting is the mechanism to ensure the equity is earned over time.

B.) Wealthfront — A Dynamic Model for Equity Distribution

Each year, you create a new option pool that addresses the following needs:

  1. New Hires: These grants are used to hire new employees at certain market levels.
  2. Promotion: These grants are intended to reward employees who have been promoted. Promotion grants should bring the recipient up to the level you would hire him or her at the new position today
  3. Outstanding Performance: These grants, made once each year, are only intended for your top 10% to 20% of employees who truly distinguished themselves on the basis of amazing accomplishments over the past year. Individual performance grants should represent 50% of what you would hire that person at for their position today. This pool should be reserved for non-executives.
  4. Evergreen: These grants, which are appropriate for all employees, start at an employee’s 2½-year anniversary and continue every year thereafter. The idea is you don’t want to wait until the employee’s initial grant has been fully vested to give a new grant because by that time the employee will evaluate new opportunities. Annual evergreen grants should equal 25% of what that employee would receive if she were hired for her same position today. Giving 25% of the market rate for a position each year, rather than a lump sum grant that covers the next four years, will smooth out the vesting process so the employee never reaches a cliff. As I said before, cliffs cause people to raise their heads to consider alternatives and should be avoided at all costs.

The Key: Consistent, Early Evergreen Grants

  • Most companies put considerable effort into the size of their equity grants for new hires.
  • Fewer companies, especially young ones, put significant effort into thinking about follow-on grants. If you tell your employees to “think like an owner,” then you need to consistently align equity with their contribution to the success of the company.
  • Evergreen grants are the most common area where technology startups fail to invest time until far too late in their development.

Instead of an ad-hoc process, the Wealthfront Equity Plan offers a transparent, consistent and fair program of equity grants that employees can build into their long-term expectations. As a result, not only do you avoid cliffs, but you also tie both long-term tenure and contribution to their ownership stake.

The best part is that, as your company grows, you always grant stock in proportion to what is fair today rather than in proportion to their original grant.

An Equity Plan that Works for Employers & Employees

Investors and employees make much more money by increasing the size of the pie rather than their share of the pie. The only reason not to implement the Wealthfront Equity Plan is greed, and greed seldom leads to a good outcome.

One final observation about companies that successfully retain employees: They usually create a culture that treats options as something dear that aren’t offered as an alternative to a cash bonus. They encourage employees to think about increasing the value of their options through accomplishment rather than asking for more upon completion of a task. It has been my experience that companies granting options for completion of milestones seldom build a culture that values equity — and therefore suffer greater turnover.

A well-designed equity allocation plan works for both the employer and the employees. The Wealthfront Equity Plan creates a tremendous incentive for people to stay at a company without costing the employer too much. That’s the kind of win-win to which we should all aspire.

C.) NCEO— Another Dynamic Model for Equity Distribution

1. Give out equity in smaller chunks more often. This will average out the lottery effects of changes in stock price while retaining flexibility to give equity to new people.

2. Focus on giving away a percentage of growth targets, not a percentage of the company. Each year, set a goal. It may be sales, profits, or something else. If you meet it, then all the eligible employees would get an amount of equity that represents a percentage of the value of meeting that target. If you meet a stretch goal, you can give out more. This lets you as the owner focus on the value of your ownership, not the percentage. It gives the employees an annual goal to shoot for, making equity awards an achievement, not an entitlement. And if you don’t meet the target, you don’t have to dilute your ownership anyway.

3. Give out ownership more broadly. Most technology companies give ownership to everyone, but so do many of the most admired U.S. companies, like Southwest Airlines, Starbucks, and Whole Foods, companies that have been “game changers” in their industries.

4. Working with the employees, figure out what amounts are needed to have a real impact on how they think about the company. If the company is small enough, you can do this on an individual basis. You might even ask employees to suggest a number and then work from there. Use surveys, if available, to set some reasonable parameters, but don’t just aim to be at or above the median.

5. Create a liquidity alternative other than sale or an IPO if neither of these events is highly likely in the near term. Somehow, a lot of people have the notion that this just can’t be done. Of course it can! It’s just a matter of finding the cash (easy for me to say). But imagine instead that you created an incentive plan that was a bonus instead of equity. People never seem to say “but how can I come up with the cash to pay the bonus?” Think of equity compensation simply as a bonus based on stock value.

Issues that may Arise

Legal Issues

The use of stock-based compensation, however, must take into account a myriad of laws and requirements, including securities law considerations (such as registration issues), tax considerations (tax treatment and deduct-ability), accounting considerations (expense charges, dilution, etc.), corporate law considerations (fiduciary duty, conflict-of-interest) and investor relations (dilution, excessive compensation, option repricing).

Corporate Laws-(mostly for larger corporations) issuance of equity from company must be accepted from state laws.

Securities Laws (must comply with state securities laws)

No Sale- employee is not required to pay for equity in the company (bonus)

Section 4(2) or Regulation D- exemption may be acquired if a limited number of employees are receiving equity who have a lot of knowledge about the company and knowledgeable about investments

Rule 701 — the issuance of an equity award by a private company will be exempt from federal registration if all of the following are satisfied:

  1. The equity award is issued in connection with written equity compensation plan.
  2. The aggregate value of the equity awards during any consecutive 12 month period does not exceed the greatest of (a) $1,000,000, (b) 15% of total assets, or (c) 15% of outstanding amount of securities of the class being offered.
  3. The equity award is being issued to an employee, director, officer, or consultant or advisor; provided that the consultant or advisor is not being compensated for services in connection with the offer or sale of securities in a capital-raising transaction, and they do not directly or indirectly promote or maintain a market for the issuer’s securities.
  4. The recipient of the equity award is provided a copy of the equity compensation plan. Note that in the event the aggregate value of the stock awards during any consecutive 12 month period exceeds $5,000,000, there are additional disclosure requirements (e.g., distributions of a summary of the plan, risk factors, and financial statements).

Tax Issues

  1. Ordinary income vs. Capital gains — equity amounts are taxed at normal rates (15–35%)
  2. Incentive Stock Options — stock issuance. ISO’s provide tax benefits for employees. however if ISO obtained will not be able to claim deductions attributed to rewards
  3. Alternative Minimum Tax — the gains that an employee sees from the stock rising in value from where it was originally issued will be subject to tax as income. Tricky law that affected way more people than congress envisioned.
  4. Section 83(b) elections — Section 83(b) of the Internal Revenue Code permits the founders to elect to accelerate the taxation of restricted stock (i.e., stock subject to forfeiture) to the grant date, rather than the vesting date. As a result, the founder would pay ordinary income tax rates on the fair market value of the stock at the time of the grant (which presumably would be quite low), with any subsequent appreciation of the stock being taxed at capital gains tax rates upon its sale. Absent an 83(b) election, any subsequent appreciation of the stock would be subject to ordinary income tax rates at the time of the vesting — which could create a situation where the founder has significant tax liability, but no cash to pay it. It is therefore advisable (subject to consultation with tax counsel) for any founders receiving restricted stock to make an 83(b) election with the Internal Revenue Service (the “IRS”). Such an election is made by filing the appropriate IRS form within 30 days after the grant/purchase date (no exceptions applicable).
  5. Section 1202 preferential tax treatment for “Qualified Small Businesses”
  • Only 50% of the gains on stock for small businesses that have been around for at least 5 years will be subject to income tax.
  • benefits employee stockholders and investors alike.

Employment Issues

A.) Employer Concerns

Practical issues can arise in connection with issuing equity to employees; including:

  1. Control — Diluting current owners, which could reduce their control over management of the company;

Minority security holders can create issues. Resale provisions should be put in place that would be triggered upon departure of an employee. Also, a nonvoting equity interest, such as a Class B nonvoting interest can be issues. Alternatively, stock appreciation rights (SARs) that are settled in cash can be awarded, which provide no rights to management but merely the right to cash- based on the appreciation in the value of the company

2. Resale Restrictions — Ensuring that the equity is not transferred to third parties who are not affiliated with the company or may not share the same views of the direction of the company.

Each employee must enter into certain agreements with buy-sell provisions that will require them to sell their equity back to the company under certain circumstances

These circumstances include:

  1. Termination of employment
  2. Sale of the company to a majority security holder (i.e. Drag along rights)
  3. Insolvency of the employee, Etc.

These transfer restrictions are also important to ensure compliance with securities laws

3. Valuation of Equity — Valuing a security that is not publicly traded.

A company also needs to determine its fair-market value in order to issue equity and/or make purchases.

Methods include:

  1. Periodic Determination by a valuation expert
  2. Book Value
  3. Formula based on a multiple of revenues, net income, or users
  • The method chosen depends on the industry, the preference of security holders and the amount of time and money they wish to spend

4. Funding Repurchases — Funding the company’s repurchase of shares

Smaller companies may not have sufficient cash flow to fund repurchases by the company.

This can be handled in several ways:

  1. Making payments over time above certain dollar amounts
  2. Using certain insurance vehicles if the repurchase occurs in connection with the death or disability of a security holder
  3. Placing Contractual limits on the dollar amount of repurchases that can be made in a year (absolute amount or % of net income)
  4. Company may also consider a line of credit to assist during seasonal periods when working capital may be low

B.) Company Protections

There are a number of protection provisions that a company will want to consider including in their employee equity documentation.

1.) Repurchase Rights

With respect to restricted stock, private companies should always consider having repurchase rights for unvested as well as vested stock. Unvested stock (and vested stock in the event of a termination for cause) should always be subject to repurchase either at cost, or the lower of cost or fair market value. With respect to vested stock and stock issued upon exercise of vested options, some companies will retain a repurchase right at fair market value upon termination under all circumstances (other than a termination for cause) until the employer goes public; other companies only retain a repurchase right under more limited circumstances, such as voluntary termination of employment or bankruptcy. Companies should generally avoid repurchasing stock within six months of vesting (or exercise) in order to avoid adverse accounting treatment.

  • These arrangements sometimes include a non-compete claw-back, under which shares are forfeited if a non-competition provision is breached, although some state laws may restrict the ability to implement this non-compete claw-back.
  • For a closely held company, however, the right to buy back shares from an employee who leaves on bad terms can avoid future conflicts and permits recycling of the equity to other employees who will build the company’s future value. Buy-back rights also provide companies with a useful tool to control the number of stockholders and avoid the need to track down former stockholders at the time of a sale.

2.) Right of First Refusal

As another means to ensure that a company’s stock remains only in relatively few friendly hands, private companies often have a right of first refusal or first offer with respect to any proposed transfers by an employee. Generally, these provide that prior to transferring securities to an unaffiliated third party, an employee must first offer the securities for sale to the company-issuer and/or perhaps other shareholders of the company on the same terms as offered to the unaffiliated third party. Only after the employee has complied with the right of first refusal can the employee sell the stock to such a third party. Even if anemployer was not contemplating a right of first refusal, outside venture capital investors are likely to insist on these types of provisions.

3.) Drag Along Rights

Private companies should also consider having a so-called “drag-along” right, which generally provides that a holder of the company’s stock will be contractually required to go along with major corporate transactions such as a sale of the company, regardless of the structure, so long as the holders of a stated percentage of the employer’s stock is in favor of the deal. This will prevent individual employee shareholders from interfering with a major corporate transaction by, for example, voting against the deal or exercising dissenters’ rights. Again, venture capital investors often insist on this type of provision.

4.) Founders Activities

“Each of the founders shall devote 100 percent of his professional time to the Company. Any other professional activities will require approval of the Board of Directors”.

No-win situation for the founder:

  1. If a founder is actually working on something else at the same time and it is not disclosed; the founder is violating the terms of the agreement in addition to breaching trust
  2. If you disclose the activities, you will reinforce the concern the VC has

C.) Employment Issues

Most common lawsuits entrepreneurs face are on the receiving end of one of these employment issues:

  1. They are an unfortunate result of today’s work context
  2. Everyone you hire should be an at-will employee
  3. If these are in the offer letter you may not be able to fire someone
  4. Consider whether you want to prebake severance terms into an offer letter
  5. If you don’t decide this on the outset, you can be left in a situation where you are able to fire someone, but they claim that you owe them something on the way out

D.) Proprietary Information and Inventions Agreement

“Each current and former officer, employee, and consultant of the company shall enter into an acceptable proprietary information and inventions agreement”.
  • Benefits both the company and investors
  • Simply a mechanism that investors use to get the company to legally stand behind the representation that is owns the intellectual property

— — — — — — — — — — — — — — — — — — — — — — — — — — — — — —

For many entrepreneurs, the legal hat can be overwhelming and an annoyance. Regardless, its important. Lawyers aren’t cheap. I hope that this blog is a helpful starting point for someone, but please don’t just read my blog post alone. There’s plenty of lawyers and firms that help promising young startups pro-bono or will defer fees til you raise a seed round.

If you found this post was worth your time spent, please click the ‘♡’ to recommend it to more people. Thanks for reading.

Sources:

Venture Deals by Brad Feld

Some other good readings defining appropriate compensation:

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