Exploring the in’s and out’s, what if’s, and but’s for C-Suite matters.
BY ERICA KERMAN, SENIOR ASSOCIATE
As an early-stage founder or executive, you may be asked for equity by employees, potential hires, advisors and others. Here are some pointers so you feel on top of the game in those conversations.
1. When and why issue equity in your company?
Companies will often grant equity to initial hires and contractors who provide key services to the company. There are several reasons why you may grant equity in your company, but two of the most common are:
• To attract and retain employees and service providers.
• To incentivize employees and service providers to work toward increasing the value of your company.
2. Now that you’ve decided to grant equity—what next?
First, consult with a trusted advisor to make sure you have an equity incentive plan in place that is appropriate for your business structure, company size, and employee population. There are different types of equity awards you’ll need to consider–each of which has its own tax consequences and accounting treatment. Your business structure will also be key in determining which type of equity awards you can offer employees. Corporations and limited liability companies, for example, have different ownership structures from each other, and thus, different options for the awards they can offer.
3. A corporation may offer employees:
Typically issued to founders and initial employees at the earliest startup phase. Restricted stock is not fully owned and is non-transferable, until certain conditions are met: typically continued employment or other company milestones. Such a timeline is referred to as a vesting schedule.
Typically granted to non-founder and non-initial employees (although founders and initial employees can also be granted options) while a company is in its earliest growth stages. An option represents the right, but not the obligation, to buy shares of stock at a fixed price (the “exercise price” or “strike price”) after a certain date. There are two categories of Options: (a) Incentive Stock Options (“ISOs”) which may only be granted to employees. These get favorable tax treatment as long as certain prerequisites are met (which they usually can be), and (b) Non-qualified Stock Options (“NSOs”) which may be granted to employees and non-employee service providers (i.e. independent contractors).
Stock options require a company to use a reasonable valuation method, as explained in Internal Revenue Code Section 409A, to get an appropriate exercise price for the options. A valuation can generally be used for 12 months unless certain specific events have occurred in the past 12 months warranting a new valuation. Those include things like: a new financing round, receipt of a term sheet for an acquisition or financing, or the creation or acquisition of significant new intellectual property.
Like restricted stock, Options are usually subject to a vesting schedule, with the optionee forfeiting all unvested Options when their employment or service ends. Optionees typically have three months from the date of termination to exercise their vested Options and purchase actual shares of stock.
These deadlines, and other restrictions on an Optionee’s rights, will be included in an Option grant document and the company’s overarching Option plan.
4. Options we’ve seen in the real world:
In our work with a very early-stage SaaS company—in 2021, before any employees were hired—we advised the company’s founder and CEO in creating an employee stock option pool, with a generous ~20% of the company’s common stock set aside for grants to employees and consultants. After that, the company obtained an independent appraisal of the fair market value of its common stock (a “409A Valuation”) so that it could award options to employees and consultants with an accurate and acceptable Strike Price (aka Exercise Price).
The first hire, the COO, was granted 5% of the company’s stock, fully vested, coming out of the pool. Its second hire, the CRO, was granted 5% of the company’s stock out of the pool, but in the form of options. As additional incentive to grow the business, the CRO was also granted the ability to earn additional options once pre-determined annual revenue milestones were met.
The company has continued to grow and hire additional employees and consultants, simultaneously granting options as part of its compensation packages. Employees have received ISOs, and contractors NSOs, each using an exercise price based on the company’s fair market value through the 409A Valuation. The company uses cap table management software to maintain a current list of all owners of stock and options in the company.
Restricted Stock Units
Typically granted by mature, highly valuable companies to employees when the fair market value of shares is too high to motivate them through options. Restricted stock units give recipients the right to receive either a specific number of shares or cash equivalent to the value of those shares. No shares are issued and no cash is set aside for the payment of these awards when they are granted. For these awards, vesting means that the awards have become issuable (for stock-settled awards) or payable (for cash-settled awards) and are no longer subject to forfeiture when employment ends.
5. A limited liability company may offer employees:
Because LLCs do not have common stock and are less regulated by their state laws, they can offer employees ownership in the company through the grant of membership interests, either in the form of a percentage ownership of the company or a number of membership units.
There are generally two categories of membership interests which have different tax implications from each other and from stock in a corporation. Owning either form of interest will qualify the recipient as a member (aka owner) of the LLC.
These are granted in exchange for a contribution of cash or property, and the owner has the right to a share of the proceeds if the company’s assets are sold at fair market value and the proceeds distributed in a complete liquidation of the company.
These are granted in exchange for a contribution of services, and the owner has the right to receive a percentage of future profits (but not existing capital) from the company. In essence, the recipient is merely participating in the company’s profits from point of grant.
There are certain tax laws that are triggered when someone becomes a member in an LLC (through the grant of Capital Interests or Profits Interests) that impact whether they can be treated as an employee under the Internal Revenue Code; you should consult an attorney before granting membership interests in your LLC. Sometimes an LLC will award phantom membership units to its employees to avoid any unintended tax consequences. Phantom Units do not confer ownership rights but entitle the recipient to payment upon a liquidity event equal to the value of the equivalent number of units.
6. Membership interests we’ve seen in the real world
For one of our early-stage LLC clients, we created a long-term incentive plan that allows the company to grant employees and consultants several different types of awards, including restricted profits interest units, phantom units, distribution equivalent rights, and others. Its first few employees were granted restricted profits interest units. They then became members of the LLC – each getting a different number of units and thus a different share of future profits in the company, depending on seniority level. Each one has its own individual restricted unit agreement which has terms related to vesting, restrictions on transfer, and the company’s right to buy back vested units if and when they leave the company.
In the future, the company may decide to award phantom units to employees and consultants as their incentive plan allows. Phantom units can be attractive to both companies and recipients because they incentivize recipients to grow the company while avoiding adding new members into the LLC.
7. Additional considerations when granting equity
Once you have decided what kind of equity plan is appropriate for your company, the company will need to obtain the appropriate approvals to establish the plan. For a corporation, it may require the consent of the Board of Directors, and sometimes the company’s existing stockholders. For an LLC,
it may be the consent of the Board of Managers and sometimes its Members. The company will also want to maintain a current cap table (a list of the company’s securities and the individuals and/or entities that hold them) which can be maintained in house, but we often advise our clients to use an outside vendor.