Negotiating Equity in a Startup: Everything You Need to Know
When negotiating equity in a startup, employee ownership is an option to consider.3 min read
When negotiating equity in a startup, employee ownership is an option to consider. Often small businesses would like to share company ownership with their employees, but are hesitant to take on legal costs and confused by the complexities of choosing a plan.
Benefits of Employee Ownership
Depending on the business structure, owners have different options to share equity interest with their employees. Stocks and restricted stocks are common options; however, if the company is an LLC (limited liability company), it doesn't have stock to share.
A company may decide to share ownership with its employees for many reasons. Companies could take an idealistic approach, believing that it's only fair to share ownership with employees. This decision can also be a practical move for the company. Doing so can:
- Increase employee retention.
- Help with owner buyout.
- Share the responsibility of entrepreneurship.
- Raise capital.
- Improve employee performance.
- Provide tax benefits.
In the legal sense, ownership of a business entails certain rights. Rights include:
- Making decisions on how the business is run
- Selling the part of the business owned
- Surplus value of the company if the company is sold
In companies that are not employee-owned, employees receive company income through wages only.
Ownership rights vary depending the way the business is structured. Businesses are set up in one of three ways:
- Sole proprietorships. A single person owns the income, business property, and is responsible for company liability.
- Partnerships. Employee ownership is difficult in partnerships, given the large amount of responsibility given to each partner. The more partners involved, the higher the risk of running into issues.
- Corporations. LLCs don't have stock, but do have "membership interest."
Understanding the Terms Used
The two most common types of employee equity are likely to encounter are:
- Options. These let employees purchase stock during a set period for a set price.
- Restricted stock. This is common stock but has some restrictions, ex. a vesting schedule or a clause stipulating special cases where the company can buy back stock.
Equity agreements typically include a vesting schedule to provide employees incentives to remain with the company.
A vesting period is a period of time when shares aren't owned outright by the employee. Taking options as an example, employees are given a certain amount of shares that the employee will own after a period of time with the company. In the case of stocks, employees do own the stock from the get-go; however, if the employee leaves the company, the company can repurchase the stock at the price the employee originally paid.
Cliff vesting is a type of vesting set to occur at specific times in the employee's tenure with a company. The majority of employee equity plans state that the employee must work for the company for one year before options and stocks vest. This also means the employee receives a full year of equity at once.
Asking the Right Questions
Make sure the vesting schedule makes sense. Perhaps the most common vesting schedule is four years with a one-year cliff. However, this schedule doesn't fit everyone's needs.
Ask when the company can repurchase employee stock and at what price. Companies may put provisions in place that simply state they can repurchase stock when an employee leaves the company. If the stock has tripled in value since the employee bought it, the company will have a big advantage buying stock back at the original selling price.
Taking Taxes Into Consideration
Whether you immediately own stock or have stock options, giving you the option to purchase stock later, your taxes will be affected.
In some situations, say a startup company that has low valuation, it may make more sense financially to go for restricted stocks over options. In this case, you would pay income tax on the shares when they are fairly low in value. If the company fails, you wouldn't have lost a significant amount of money on taxes. If the opposite is true, you'll be paying higher taxes on stock that may not vest before you quit the company. In this case, it would be a wiser choice to go for stock options.
If you need help negotiating equity in a startup, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.