Equity Incentives: The types, ideal amounts, and grant process

If you're reading this, you probably already know it's common for companies, including those in early stages, to offer incentives to employees in the form of equity or equity equivalents. Why? Because equity incentives can help in attracting and retaining talent at any company, and in early-stage companies, equity incentives may also be used to compensate personnel if the company is not yet able to pay market-rate salaries.

But it's not all straightforward. Equity incentives can be complicated from both a legal and tax perspective. Below are some frequently asked questions that we receive in regard to equity incentives.

While the below is not an exhaustive list, these are the most common incentives:

• Stock Purchase/Stock Grant -- an outright grant of equity. These grants may sometimes be called a “Restricted Stock Purchase/Grant” when vesting provisions are included. When effected, the recipient is an owner of the company, with all rights of a shareholder. This type of grant is most common for very early-stage companies when the fair market value of the shares is relatively low. Equally common in LLCs or corporations.
• Stock Options -- provides the recipient the right to purchase shares in the company at a later date. The purchase price is locked in as of the date the option is granted. The grantee is not an owner of the company unless and until the grantee exercises the options. Generally, options are granted by corporations (not LLCs) for tax reasons. This is most common for growth-stage companies who are planning to add several employees. Usually, a “pool” of the company’s shares is reserved for these types of issuances.
• Profits Interests -- provides the recipient with the right to receive certain future profits of an LLC. This is a grant of equity, but the grantee holds a different “class” of equity, which does not participate in profits unless and until the value of the company’s stock rises above the value on the date of grant. This is more typically used for companies that plan to remain LLCs and do not expect institutional investment.
• Restricted Stock Units (RSUs) -- provides the recipient the right to receive the equivalent value of a share of stock, but this is not stock, and the grantee is not a shareholder of the company. However, the right can be paid out in cash or stock, so the grantee could become a shareholder of the company at a later date.
• Stock Appreciation Rights -- entitles the recipient to any gain in value between the value of company stock at the time of grant, and the value at the time of exercise (it does not entitle the grantee to the original value of the stock, unlike an RSU). Similar to RSUs, this is not stock, and the grantee is not a shareholder of the company, unless this right is paid out in stock instead of cash.

Note that vesting provisions can be associated with any of the above. The type of equity incentive a company chooses to offer is likely going to be highly influenced by tax implications. We recommend consulting with both your legal counsel and tax counsel before deciding on the type of incentive to be granted.

How much equity should be granted?

There are no definitive rules when deciding how much equity to offer an employee, advisor, or consultant. Ultimately, it is a negotiation between the company and the individual. The stage of the company, and experience level and expectations for the individual, are major factors. If you are a startup bringing on a key employee who will take a management role and help shape the growth of the business, it may be reasonable to start your thought process in a range of 1% - 5% of the company. The final number is highly dependent on the stage of the company, and how critical the individual is to the business. Keep in mind that equity can always be tied to vesting provisions, which can help a business ensure it does not grant equity without return on value from the grantee.

As a company’s growth continues, and employees are hired who are not management-level or as critical to the continued growth of the business, the percentage of equity offered will generally reduce significantly. By this time, a company should have an employee incentive pool in place. The company’s management team should evaluate the availability in the pool in light of the number of planned hires, and such team may also want to develop standards for issuance based upon role and levels of experience.

What is the process of an equity grant?

It is absolutely critical to appropriately document equity grants.

First, this ensures that the equity incentives align with expected tax treatment.

From a legal perspective, unless and until there is documentation in place actually transferring a specific number of shares to a grantee, the grant may not be effective. It is not effective to simply add someone to your internal cap table, or to reference a future equity grant in an offer letter. For example, some popular advisor and consultant agreements found online state that equity will be granted later, but do not serve to actually grant the equity. To that end, offer letter language should be specifically drafted to avoid any confusion between the parties in regard to the number of shares to be granted, the vesting schedule, and any pre-conditions to the grant (such as board approval).

The longer a company waits to formally document equity incentives, the more complicated those grants will become from both a tax and legal perspective. If you are in a position where you desire to grant equity incentives (or have already promised equity incentives), we can assist you with deciding on the type of equity to grant, and getting the appropriate documentation in place.