You need to understand equity as soon as you are ready distribute stock. The decisions made here will affect your company for years to come.
Offering equity is a great way to keep employees invested in their work. It allows them to own a piece of the company and gives them a personal reason to help it succeed.
However, equity can be difficult to understand and manage. Here, we’ll help you understand the basics so you can use equity to incentivize and retain employees.
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What is equity?
Equity is any type of security that represents an ownership interest. This can include:
- Shares of stock in a corporation
- A membership unit in a limited liability company (LLC)
- A partnership unit in general or limited partnerships
What are the most common types of startup equity?
Common stock is the most basic form of stock. It’s mainly issued to founders and employees.
Preferred stock is mainly issued to investors, who usually pay a higher price per share. In exchange, these shareholders are paid out first in a liquidity event or bankruptcy.
What kind of equity is issued to employees?
Early-stage companies usually issue employee stock options, which are the opportunity to purchase shares of common stock at an agreed-upon price. At most companies, the employee has to work at the company for a certain period of time or meet specific milestones to earn the right to exercise their options (purchase their shares). However, your equity plan can allow early exercising, which lets them exercise their options as soon as you grant them.
There are two main types of employee stock options:
- Incentive stock options (ISOs): ISOs are the most common type of security issued to employees. They are more favorable than NSOs because ISO holders don’t have to pay taxes when they get the grant or exercise their options (except for the Alternative Minimum Tax, if applicable).
- Note: under IRS rules, individuals can’t treat more than $100K worth of exercisable options as ISOs in a year so that people can’t abuse this tax benefit.
- Non-qualified stock options (NSOs): NSOs are typically issued to outside contractors, consultants, international employees, or later-stage company employees. Unlike with ISOs, you have to pay taxes both when you exercise and sell NSOs.
As companies grow larger, they sometimes decide to issue restricted stock, like RSAs or RSUs, instead of options. With restricted stock, you give employees shares when certain restrictions are met. Companies usually switch to restricted stock to reduce stock dilution.
Where do stock options come from?
Usually, you distribute options from an option pool, which is an amount of common stock reserved for future employees.
What is a vesting period?
A vesting period is a length of time or a milestone that must be met before employees can gain ownership of their options.
The lifecycle of an option usually looks like this:
- Grant: When you give an option grant to an employee (usually on their hire date). While you can include information about their equity compensation in your offer letter, you should also send them an official stock option agreement that spells out everything they need to know, like what type of stock they get, how many shares they get, and more.
- Cliff: When the first portion of the option grant vests and the employee earns the right to exercise their options. Many companies make the cliff the employee’s one-year anniversary and call it a one-year cliff.
- Fully vested: When all of an employee’s granted options have vested and are exercisable. (Many companies offer refresh grants when an employee vests all their options to continue motivating the employee to stay and help the company succeed.)
- Exercise: When an employee exercises all or a portion of their vested options. If your company is based in the U.S. and you designate us as your Transfer Agent, your employees can exercise directly on our site or mobile app.
- Sale: When an employee sells all or a portion of their equity stake. If you’re a private company, this usually only happens if you have a liquidity event, like a tender offer, or exit the private market by getting acquired or going public.
What is a post-termination exercise (PTE) period?
A post-termination exercise (PTE) period is how long your employees have to exercise their options after they leave the company. Historically, many companies gave employees 90 days. However, many companies now offer a much longer PTE period, and you can as well if you want to be fairer. At Carta, for example, we give employees a period equal to the amount of time they worked at the company.
If employees don’t exercise their options before the PTE period ends, those options (and any unvested options) go back into your option pool.
What is a strike price?
Every stock option has an exercise price (also called a strike price), which is the price an employee pays to purchase one share. The IRS requires that the exercise price must be at least the fair market value (FMV) of one share when you give the employee their grant. This means if your shares were worth $0.25 when an employee started, that’s the minimum amount they can pay to exercise their option to purchase one share—even if your company’s shares become more valuable over time.
How is FMV determined?
409A valuations are often used to determine the FMV. Most companies use this price as the strike price for option grants.
How do companies keep track of employee equity?
Cap tables track who owns what in your company.
Understanding equity and ownership is something you need to prioritize when you’re ready to incorporate and distribute stock to co-founders, early investors, and employees. Knowing the basics can help you start your companies off on the right track, avoid broken cap tables, and reduce your legal fees.
If you’re just getting started, your lawyer can onboard you onto Carta Launch, where you can manage your cap table for free. It’s available for companies with up to 25 stakeholders that have raised up to $500K. Learn more about Launch or contact your lawyer to get set up.
Special thanks to Steven Kakowski for writing the first version of this article.
DISCLOSURE: This communication is on behalf of eShares Inc., d/b/a Carta, Inc. (“Carta”). This communication is not to be construed as legal, financial or tax advice and is for informational purposes only. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein.
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