Key Takeaways

  • An equity contract can represent different financial or ownership arrangements, from convertible debt to startup ownership and employee equity.
  • Equity forward contracts let investors fix future prices for stocks or portfolios and are useful for managing risk.
  • Equity agreements define ownership distribution and responsibilities among partners or stakeholders.
  • Employee equity contracts are commonly used in startups and must be carefully structured to comply with tax and employment law.
  • Distinctions between equity and debt contracts center on control, repayment obligations, and investor risk.

Contract equity refers to a convertible bond with either a mandatory conversion or mandatory redemption feature that the owner is able to exchange for common stock when the bond reaches maturity. The market value of the common stock must match the amount of the equity contract note's principal value. When the equity contract bond owner doesn't want the common stock offered, the note is sold to settle the conversion for the owner, who then receives cash in lieu of the common stock.

Equity Forward Contracts

An equity forward contract is for buying a single stock, a portfolio of stock, or a future-dated stock index. The equity forward on these stocks works in specific ways:

  • Individual stock lets the investor make a sale of stock in the future at a price that's guaranteed.
  • If the guaranteed price ends up being lower than the market price when the time of the sale arrives, the investor still gets the price that was guaranteed.
  • However, if the market price when the time for the sale arrives is higher than the guaranteed price, the stock owner still gets only the guaranteed price and not the higher market value.
  • Equity forward contracts on stock portfolios function in the same manner as forward contracts on individual stocks.
  • Dealers create a quote for the future price of securities based on a list of the bonds that are held in a portfolio instead of entering a separate contract for each security on a separate basis.
  • Forward contracts on stock indexes give managers of portfolios the opportunity to protect a portfolio's value and reduce or completely eliminate the risk of a portfolio that copies a major stock index.
  • Rather than contracting for each security, a manager is able to enter a forward contract that allows for selling the index at a preselected future date.

Equity Agreements

An equity agreement details the way a group of partners in investing divide ownership when a new business is started. The agreement lists how payoffs, profits, responsibilities, and stocks are divided among the partners. These documents are legally binding agreements prepared by an attorney. However, standard agreements can be found online. These agreements can be very simple or extremely complex.

Startup Equity Contracts and Considerations

Startup founders often use equity contracts to divide ownership among themselves, early employees, or investors. These agreements not only define the percentage of ownership but also include protective provisions like:

  • Founder vesting schedules to prevent a co-founder from leaving with full equity.
  • Buyback rights or clawback clauses in case an employee leaves early.
  • Drag-along and tag-along rights to protect minority shareholders.
  • Equity dilution provisions to explain how future fundraising rounds will impact ownership.

Clarity in these contracts helps avoid disputes and positions the company for smoother fundraising and growth.

Employee Equity Contracts in Employment Agreements

An equity contract can also refer to an agreement that grants employees ownership interest in a company, often as part of their compensation. This is particularly common in startups and high-growth companies where cash flow may be limited.

These agreements typically outline:

  • The type of equity (e.g., stock options, restricted stock units, or direct equity grants)
  • Vesting schedules (e.g., four-year vesting with a one-year cliff)
  • Conditions under which the equity is forfeited (e.g., termination or resignation)
  • Rights associated with the equity (e.g., voting rights, dividend rights)

Incorporating equity into employment contracts requires compliance with tax rules, such as Section 409A of the Internal Revenue Code for deferred compensation, and securities laws if issuing actual shares. Companies should document all grants clearly and track them to avoid dilution errors or legal disputes.

Complex or Simple Equity Agreements

Complex equity agreements typically require the services of a lawyer. An agreement becomes complex when involving multiple partners, unusual or intricate details regarding repaying investors or distributing profits, and even the consideration of employees as investors.

If the list of partners is small, a simple equity agreement is suitable. Simple equity agreements include such details as:

  • Company name
  • Investor names
  • Contract duration
  • Amounts invested by each partner
  • How funds invested will be used
  • Investor returns
  • Signature of all involved parties
  • Notarization

Why Partnership Equity Agreements Are Necessary

Even if your partner is your best friend, things can quickly dissolve when you start to discuss what you each get for your investment and what each partner has to do as part of the partnership. Asking your partner to sign a partnership agreement doesn't mean you doubt your partner's integrity. It protects your interests. It also details the roles and responsibilities of each partner, as well as the rewards for fulfilling those roles and responsibilities.

Equity and Debt

Debt and equity are two ways to classify the funds that pass between savers and investors. The two main contractual forms a person or company can use for funding are equity and debt. One exception is that governments have only the option to raise funds from debt because only businesses are permitted to raise equity.

  • With a debt contract, the lending party provides funds and the borrower repays at a predetermined time along with interest.
  • As long as debt contract payments are made promptly, the borrower is able to make all decisions about how to manage the business and assets.
  • With an equity contract, the borrower makes payments to the shareholders from the profits earned by the business.
  • Shareholders in an equity contract sometimes prefer to reinvest the profits to maximize future returns.

One problem sometimes noted by shareholders with this type of funding is not knowing how the borrower is managing the funds the shareholder has invested.

Industry-Specific Equity Contracts

Equity contracts may take on different meanings and structures in specific industries. For instance:

  • Entertainment industry: Performers under Actors’ Equity Association (AEA) contracts may be guaranteed certain payments and working conditions under equity contracts related to theatrical productions.
  • Technology startups: Equity contracts are often used as part of stock incentive plans to attract and retain talent in lieu of higher salaries.
  • Law firms and consultancies: Equity partner agreements define ownership percentages, profit-sharing, and decision-making authority.

Understanding the industry context is crucial for drafting enforceable and practical equity contracts.

Key Legal and Tax Implications of Equity Contracts

Equity contracts can trigger a range of legal and tax considerations. For example, granting equity as compensation may be subject to income taxes upon vesting or exercise, depending on the structure. Common tax-related implications include:

  • 83(b) election: Employees receiving restricted stock can choose to pay taxes upfront on the value of the shares at grant instead of at vesting.
  • Capital gains treatment: Long-term holding of equity may qualify for favorable capital gains tax rates, whereas short-term sales may be taxed as ordinary income.
  • Valuation compliance: Companies must ensure fair market valuation (e.g., via a 409A valuation) when issuing options to avoid IRS penalties.

Additionally, equity contracts must comply with federal and state securities regulations, especially in private companies offering stock to employees or consultants.

Frequently Asked Questions

  1. What is the difference between an equity contract and a debt contract?
    An equity contract involves ownership in a company and returns based on profits, while a debt contract involves a loan with fixed repayment terms regardless of company performance.
  2. Can employees receive equity instead of salary?
    Yes, startups often use equity compensation, but it must be structured to comply with employment and tax laws, including proper disclosures and vesting terms.
  3. What does an equity contract include for founders?
    Founder equity contracts typically include ownership percentages, vesting schedules, rights upon exit, and provisions for what happens if a founder leaves.
  4. Are equity contracts legally binding?
    Yes, when properly drafted, equity contracts are enforceable legal agreements and must comply with relevant corporate, tax, and securities laws.
  5. How do equity contracts impact company valuation?
    Issuing equity affects a company’s capitalization table and can dilute existing ownership. Proper documentation helps maintain accurate investor records and ensures transparency.

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