What to Consider Before Offering Equity Compensation
When you provide equity compensation, you give some of your ownership in your company to your employees. When a public company provides equity, employees can sell their stock and make money right away or when it vests.
If you own a startup or small business and aspire to go public or get acquired, there are still benefits to offering equity now. Here are key considerations and the exact steps to take if you decide to make equity part of your compensation package.
What is Equity Compensation?
While there are a variety of ways to offer stock to your employees, the two most common methods are:
- Stock Options: You give employees the opportunity to buy or sell a specific number or percentage of shares at an agreed-upon strike price if the company goes public, is acquired, or they leave the company and want to sell their stock back.
- Stock Grants: Stock grants are like stock options except you’re giving the employees the stock. They do not need to buy it from the company. The value of the stock is whatever the market value is at the time the company goes public or is acquired.
The Benefits of Offering Equity
When public companies give stock options and grants there’s already a monetary value. Because your company is private, the stock options and grants don’t have a monetary value yet, but they could be lucrative in the future. Here are the main reasons you may want to offer equity at this stage:
1. Pay Lower Salaries
You may want to spend most of your capital on expanding your products and services and growing your team. When you offer equity compensation, candidates may be willing to work for a lower salary now if they think they will ultimately have a windfall if the company is successful. Instead of paying large salaries, you can hire more employees.
2. Recruit Top Talent
It’s difficult to attract top talent if you’re offering a salary that’s lower than the market rate. Offering equity can incentivize talent to join at a lower salary.
In some instances, people may be willing to “work for equity.” This means they will earn a stake in the company instead of a salary. However, the equity doesn’t have any value yet and many people can’t afford to take that option.
3. Increase Retention
Business owners often use equity compensation to increase retention by requiring employees to be at the company when their stock vests. The vesting date is when employees officially own the stock. Some companies set a vesting schedule, so employees get a certain percentage each year.
Many companies have a four-year vesting schedule with a one-year cliff. This means new employees don’t receive any equity until they hit a year and then get a certain percentage every subsequent year. For example, they might get 25 percent each year. If an employee leaves before it all vests, they would still own the amount that already vested.
4. Boost Employee Engagement
When your employees have ownership in the company, your team is bound to have higher levels of employee engagement and morale. People are likely to work harder and be more collaborative and committed. Companies with high levels of employee engagement and morale are often more successful.
The Potential Cons of Providing Equity
While there are clear benefits to offering equity compensation, there are possible downsides that you can try to mitigate.
1. It can be Complicated
When you’re in the early stages, it can be hard to predict the long-term valuation to set the strike price. To incentivize employees to stay at the company, the strike price should be lower than what the market value will be so people have a “discount.” If it’s higher than the market rate, it’s meaningless because people can buy shares at the lower price.
It can be easier to give a stock grant, otherwise known as a restricted stock unit (RSU), because you don’t need to anticipate the market rate. The stock will be worth whatever it is worth when you go public or sell your company.
Talk to an accountant and lawyer to make sure you follow all the necessary tax and reporting requirements. Stock options and stock grants are taxed differently, so consider having them talk to your team.
2. You Have Less Ownership in Your Company
You’re giving away some of your ownership and, depending on your terms, only get it back if the person leaves the company before it vests.
You stand to make less money from an acquisition or going public because you hold fewer shares. However, if you can’t pay high enough salaries to get the talent you need, you may not be able to get to that stage.
3. You Could Have a Harder Time Attracting Investors and Buyers
If you give away a large proportion of your shares, investors and buyers may want the opportunity to buy more shares than you can provide. You can create an employee option pool to set aside a set percentage for employees, such as 10 percent cumulatively. You’d pull from that amount to give equity to new hires.
How to Offer Equity
Here are the steps to take if you decide to provide equity compensation.
1. Create an Employee Option Pool
Your first step is to determine how much equity you want to reserve for your employees. As you hire new employees, you can see how many shares you have left and whether you will need to dilute some of your shares to add more to the employee option pool.
It’s helpful to create a capitalization table that shows everyone who owns shares in the company, including investors, and how much ownership they have. If people leave the company before their stock vests, you can decide how to redistribute it.
2. Decide the Type of Stock and Amount
Your next step is to decide if you want to offer stock options or stock grants and preferred or common stock. To determine how much equity compensation to give each employee, business owners often consider whether it’s an early employee, their seniority level, and how critical the role is to the company’s success.
Some business owners also let employees choose if they want to have more equity but a lower salary, or vice versa. You can also incentivize employees by giving them a larger stake as they get promoted. Some business owners have performance-based vesting schedules for executives, meaning their stock only vests if the company hits pre-determined key performance indicators (KPIs).
3. Create Contractual Agreements
Work with a lawyer to create contracts with each employee. If it’s relevant, you may want to include the number or percentage of shares, the strike price, the vesting schedule, a buy-sell agreement, and the expiration date.
Keep Optimizing Your HR Policies
Now you know how offering equity compensation can help you hire a larger team, attract and retain talent, and boost employee engagement and morale. Continue to strengthen your company culture and performance by receiving expert HR and management advice from Monster.