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!
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
b.) Restricted Stock Units (RSU’s)
c.) Equity Bonuses
d.) Stock Purchase Plans
e.) Stock Appreciation Rights (SARs)
f.) Phantom Stock Units
g.) Refresher Grants
By offering Equity Compensation. A private company:
1.) Performance Vesting- conditions that require the recipient to accomplish certain business objectives
2.) Service Vesting- Stock and options will vest over 4 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
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
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
Each year, you create a new option pool that addresses the following needs:
The Key: Consistent, Early Evergreen Grants
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.
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.
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:
Practical issues can arise in connection with issuing equity to employees; including:
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:
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.
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:
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.
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:
Most common lawsuits entrepreneurs face are on the receiving end of one of these employment issues:
“Each current and former officer, employee, and consultant of the company shall enter into an acceptable proprietary information and inventions agreement”.
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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.
Venture Deals by Brad Feld
Some other good readings defining appropriate compensation:
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