Equity Compensation

What is Equity Compensation?

Equity compensation has become a cornerstone of startup employment packages, allowing companies to attract top talent while conserving cash and aligning employee interests with company success. It's particularly valuable for early-stage companies that may not have the resources to offer competitive cash salaries.

Types of Equity Compensation

Stock Options

The right to purchase company shares at a predetermined price (strike price) for a specific period.

Incentive Stock Options (ISOs): Tax-advantaged options for employees with specific holding requirements.

Non-Qualified Stock Options (NQSOs): More flexible options available to employees, contractors, and advisors.

Restricted Stock Units (RSUs)

Company shares granted to employees that vest over time, with recipients receiving actual shares upon vesting.

Benefits: Simpler than options, have value even if stock price declines.

Considerations: Recipients may owe taxes upon vesting, regardless of whether shares are sold.

Restricted Stock Awards (RSAs)

Actual shares granted upfront that are subject to vesting restrictions and potential forfeiture.

83(b) Election: Allows recipients to pay taxes on current (low) value rather than vesting value.

Stock Appreciation Rights (SARs)

Cash or stock payments equal to the appreciation in stock value over a specified period.

Employee Stock Purchase Plans (ESPPs)

Programs allowing employees to purchase company shares at a discount, often through payroll deductions.

Vesting Schedules

Standard Vesting

4-Year Vesting with 1-Year Cliff: Most common structure where 25% vests after one year, then monthly vesting for remaining 36 months.

3-Year Vesting: Faster vesting for senior roles or competitive markets.

5-Year Vesting: Longer retention for critical roles or specialized positions.

Acceleration Triggers

Single Trigger: Vesting accelerates upon specific event (acquisition, IPO).

Double Trigger: Requires two events (acquisition AND termination without cause).

Partial Acceleration: Only a portion of unvested equity accelerates.

Equity Pool Management

Option Pool Sizing

Typical equity pools for employees:

• Pre-Series A: 10-20% of company
• Series A-B: 15-25% total
• Later stages: Refresh with 5-15% additional pools

Pool Allocation Strategy

• C-level executives: 1-5%
• VP level: 0.5-2%
• Director level: 0.25-1%
• Senior individual contributors: 0.1-0.5%
• Individual contributors: 0.01-0.25%

Tax Implications

For Employees (ISOs)

• No tax upon grant or exercise (if holding requirements met)
• Capital gains treatment on sale if held >1 year after exercise and >2 years after grant
• Potential Alternative Minimum Tax (AMT) upon exercise

For Employees (NQSOs)

• No tax upon grant
• Ordinary income tax on spread at exercise
• Capital gains on subsequent appreciation

For Companies

• Tax deduction equal to employee's ordinary income recognition (NQSOs and disqualifying ISO dispositions)
• No deduction for qualifying ISO exercises

Best Practices for Startups

Plan Design

• Establish equity compensation plan with board approval
• Set aside appropriate option pool size
• Define clear vesting schedules and acceleration terms
• Include standard provisions for termination scenarios

Grant Management

• Conduct regular 409A valuations for strike price setting
• Document all grants with proper agreements
• Maintain cap table accuracy
• Communicate equity value and terms clearly to recipients

Compliance Considerations

• Follow securities law requirements
• Ensure proper plan registration and filings
• Maintain accurate records for tax reporting
• Consider state-specific requirements

Equity Communication Strategy

During Hiring

• Explain equity terms clearly and honestly
• Provide context about company stage and growth potential
• Use equity visualization tools to illustrate potential outcomes
• Set realistic expectations about liquidity timelines

Ongoing Education

• Regular equity education sessions for employees
• Transparent communication about company milestones affecting equity value
• Clear explanation of vesting schedules and exercise considerations
• Updates on company valuation and market conditions

Common Equity Compensation Mistakes

Inadequate Pool Planning: Not reserving enough equity for future hiring needs.

Poor Vesting Structure: Using vesting schedules that don't align with retention goals.

Lack of Documentation: Inadequate equity agreements or missing grant paperwork.

Inequitable Distribution: Significant disparities in equity grants without clear rationale.

Inadequate 409A Valuations: Infrequent valuations leading to incorrect strike prices.

Poor Communication: Failing to explain equity terms and value to recipients.

International Considerations

Global Equity Plans

Different countries have varying:

• Tax treatment of equity compensation
• Securities law requirements
• Employment law considerations
• Regulatory approval processes

Common Alternatives

• Cash-settled equity awards
• Phantom stock plans
• Local subsidiary equity participation
• Cash bonuses tied to equity value

Exit Scenarios

IPO Considerations

• Lock-up period restrictions
• Market timing for option exercises
• Tax planning for concentrated positions
• Diversification strategies

Acquisition Scenarios

• Treatment of unvested equity
• Cash vs. stock consideration
• Earnout provisions
• Continued employment requirements

Equity compensation is a powerful tool for startups to attract, motivate, and retain talent while preserving cash. Success requires careful plan design, clear communication, and ongoing management to ensure alignment between employee and company interests.