Most startup companies get going with a plethora of cost-saving measures including working out of dismal (read cheap) spaces, employing sweat equity, and promising future equity. Most startups reward early hires for taking the risk and joining an unproven team by offering them company equity – after all working for a startup doesn’t always mean a big reward in the end. So, what is the right way to issue equity to startup employees?
1. Issue Equity in Alignment with Company Goals
There are different options for equity compensation depending on whether your company is a limited liability company, a C corporation, or an S corporation, but in every case it’s important to align the issuing of equity with the company’s goals. For example, if the company is poised for fast growth the the intention of going IPO then you may want to issue equity early and based on milestones. If the company will remain privately held and grow organically over time, you may want to issue equity based on longevity and based on earnings.
Either way, the liquidity of company shares should be closely aligned with your company goals because that attitude will reinforce the company culture.
2. Determine the Equity Distribution Early
When a company is in the early stages of development, many entrepreneurs fall back on the easy and cheap choice – issue restricted stock. Restricted stock means the owner of that stock becomes an owner of the company when the stock vests unlike stock options with are exercised sometime in the future.
When a startup is incorporated and while they are putting together the initial team, restricted stock is often a good choice. If the company has revenue, however, options are often the better method but getting the equity distribution under control early is always the key and working with an experienced startup lawyer can make these decisions easier for you.
3. Decide on the Company Valuation
This is always the magic question: what is the company worth? When the company becomes more valuable, restricted stock will have immediate tax consequences for the employee. Specifically, restricted stock has income equal to the difference in fair market value of the shares and the amount they employee paid for them – which is often nothing.
A well-designed employee equity allocation plan works for the employer and employees. Ideally, without costing the employer too much. In the end, both investors and employees make more money when they increase the size of the pie rather than their own share of the pie.