It can be difficult to attract talent during the start-up phase when you can’t necessarily offer the larger salaries and bonuses of a more-established company. Many start-ups turn to offering employee equity plans that increase the attractiveness of working for them. But there are downsides to diluting your equity and managing an equity plan.
If you’re a startup struggling to build the professional team you need to succeed, here are some of the pros and cons of launching an equity plan.
Reasons to Offer Employees’ Equity
Offering equity is also a great way to retain important employees. If you offer a stock grant, for example, which vests after two years of service, eligible employees are less likely to leave before the two-year mark. When they’re considering other opportunities, the possibility of losing their options could sway them to stay.
If they receive an offer from a competitor, it could be impossible to compete. A company can’t always afford to increase a key employee’s salary or offer a higher bonus. But you could offer equity as an incentive to stay.
Another reason to offer equity is to increase employee engagement and investment in your company’s results. Similar to a bonus, when they benefit from the company’s success, they’ll likely work harder to make it happen.
Downsides to Offering Equity
Obviously, offering equity to employees dilutes your equity or the equity of other shareholders. This is why many larger corporations require that the Board of Directors sign off on any equity plan. For founders, it can be hard to lose control of the company they started.
As well, as equity becomes diluted it could be harder to make strategic decisions and you’ll need to work to get buy-in from all stakeholders. It’s something to consider if you’re not ready yet to handle competing ideas for your company’s direction.
Increased administration costs are another downside to offering equity plans. A staff accountant or other expert will have to track, account for, and manage the equity plan. This could include forecasting possible exercises and their impact on overall equity, booking accruals for compensation, and responding to employee questions about their plan.
Types of Equity to Offer
There are three common types of equity plans you can offer, each of which has different tax implications for either the employee or the company.
Stock Grants
Think of a grant as a gift. If the employee is still with the company when it vests, they get the stock. Typical service periods range from two to four years, and often a grant will vest over time. For a four-year grant, the employee may receive 25% of their grant each year.
If you offer a grant, you’re required to fulfill it and the grant’s price, which is often less than the stock’s market price. Employees will have to report the grant as income, and the stock received at the market value, in the year it vests.
Stock Options
An option gives someone the option to purchase stock at a specified price. It could have the same vesting period as a grant, but the employee has the option whether or not to exercise it.
If a director has an option to purchase 300 shares at $40 a share and the market price of your company’s stock has risen to $60, they’ll likely exercise the option. If the stock is selling at $30, so less than the option price, common sense dictates that they’d let the option expire.
Choosing to offer stock options means more work for the company. You’ll have to estimate the likelihood of an option being exercised or forfeited, and accrue stock-based compensation expense accordingly. The employee who exercises the option is responsible for paying taxes on it, but how much they pay will depend upon whether they sell it right away or hold onto it for a few years.
Performance-Based Awards
Performance-based awards are more commonly offered to higher level or C-suite employees. As their name implies, the amount an employee eventually receives will depend upon performance. When the performance metric is achieved, they could receive the stock as a grant or have the option to purchase it.
An award could vest based upon reaching a target earnings per share, net income, or EBITDA number. It might also have a vesting period based upon dates of service. Forecasting potential vesting, exercises, and forfeitures becomes even more complicated than with a stock option.
Taxes and Stock-Based Compensation Plans
There are tax implications to equity plans for both employees and corporations. Corporations can deduct the share-based compensation expense on their taxes, which can impact their income statement.
If you decide to offer employee’s equity, it would be wise to discuss the type of equity and who is eligible with a tax professional. You can structure your equity plan to both incentivize employees and help the company at tax time. Because plans can become quite complex, you may need to consult several professionals and perhaps hire an outside equity administrator.
Whatever path you decide to take, the right equity plan can shepherd your company to success.