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5 Things Every Private Company MUST Understand before Launching an Equity Incentive Plan

5 Things Every Private Company MUST Understand before Launching an Equity Incentive Plan

There is a point in the life of every start-up when it needs to establish a plan to reward its employees for their service by giving them a piece of the pie, i.e., their share of the potential upside. Being a 100% upside person myself, most employees drawn to start-ups tend to be more interested in the possibility of hitting a home-run rather than the fixed cash payment every month.

Most private companies offer equity as part of the compensation package: in comes the first equity incentive plan. Stock compensation is complex, and there are many rules. This guide will help you understand the key components to determine the right equity compensation structure. Here’s what you need to know:

There are different types of equity awards. Decide which one is right for your company and that particular employee.

The most common are stock options (which are either Incentive Stock Options [ISOs] or Non-qualified Options [NSOs], see below), restricted stock, restricted stock units and stock appreciation rights. Employees understand options best, but all the types of awards have pros and cons that are driven mostly by the tax impact on the employee and the company. Most companies will want to structure the award so that the employee will ideally not get hit with a tax upon grant or vesting—after all, many employees will not be able to come up with the necessary cash if the stock they receive is not exercisable or liquid. You don’t have to stick with one type, not even for the same employee, if more than one batch is granted. As I said, the decision will largely be driven by the tax effect, which may change dramatically when the company’s value increases. To describe the differences between the types of awards (other than ISOs and NQOs) is beyond the scope of this piece, so stay tuned for another post on it. I would advise you to include the authority to grant a variety of different awards in your plan for maximum flexibility.

There is a big difference between ISOs and NSOs.

Most private companies award their employees ISOs to the extent possible. ISOs typically are beneficial to employees because regular federal income tax is not triggered upon exercise (although the alternative minimum tax may be) and sales of ISOs, once exercised, enjoy long-term capital gains treatment if certain minimum holding periods are met. Among other restrictions, ISOs can only be granted to employees. NSOs are taxed upon exercise (as opposed to when the underlying stock is sold) based on the difference between the strike price of the option and the fair market value of the stock at the time of exercise. Also, NSOs are taxed at ordinary income rates, not capital gains. Note, though, that to retain ISO treatment, the company and employee must comply with a number of conditions, which are often not feasible. Check with an accountant/tax advisor to understand the details of the limitations.

Equity awards typically don’t kick in immediately—they vest over a period of time or when the company hits agreed upon milestones.

When employees receive stock options or other types of awards, they are put on a vesting schedule, meaning that the employee will have to be with the company for a period of time before he or she earns the award, or the award vests when the company hits certain milestones. The most common vesting schedule is four years, with a one-year cliff, meaning the employee has to be with the company for a year before he or she get the first 25% of their shares, and then there is usually equal monthly vesting. Ultimately it’s up to you to offer employees what you think is fair and what you both think their minimum tenure will be, and you may consider giving them some credit for the time they put in before the grant. Performance-based vesting may be based on revenue targets or getting a financing done, for example. Again, structure something that suits the trajectory of the company and the employee’s contribution to it.

Often an equity grant includes acceleration provisions.

In many cases, equity grants will include acceleration provisions for the employee, most commonly seen in the event of a sale of the company. You will have to decide whether to apply a “single trigger” or a “double trigger” acceleration. Single trigger means that all stock vests automatically when the company is sold. Double trigger is the most common type of acceleration for employees and requires the sale of the company and the termination of the employee, either without cause or by the employee for good reason, within a specified period after the sale.

Transferability of shares is typically limited and companies almost always have a right of first refusal to buy shares employees want to sell.

Nearly every private company’s common stock will be subject to a right of first refusal in favor of the company and other transfer restrictions. A right of first refusal means that prior to selling vested shares, an employee must give the company the ability to purchase the shares on the same terms as a third party that would like to buy the shares. Many companies also include general transfer restrictions on their shares so that they can’t be sold without the company’s consent, with specified exceptions. You may also want to think about a drag-along in the event of the sale of the company and a right in favor of the company to repurchase vested shares. Unvested shares are typically not transferable.

Again, watch out for follow-on posts with more details on the components outlined above. This post covers the main business points that you should spend some thought on to get started.

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