Equity grants are an increasingly popular compensation tool for startups and established businesses alike. Let’s dive into what they are, how they work, and their benefits.
What is an equity grant?
An equity grant provides an individual the right to purchase or receive shares in a company. This can be in the form of stock options, restricted stock units, or other equity-based awards. Essentially, it’s a way for a company to share a portion of its value with its team members.
How do equity grants work?
Equity grants are a form of compensation offered by companies, particularly startups, to reward and retain their employees, directors, advisors, and other stakeholders. This compensation is provided in the form of ownership in the company. Here’s a breakdown of how equity grants work:
1. Determination of the Grant
- The company decides to offer equity as part of its compensation package.
- The Board of Directors or a designated committee generally approves the specifics of the grant, such as the number of shares, type of equity, and terms associated with the grant.
2. Types of Equity Grants
There are various forms of equity, including:
- Stock Options: Gives employees the right to buy shares at a pre-determined “strike price”. They can be either:
- Incentive Stock Options (ISOs): Offer tax benefits but come with specific restrictions.
- Non-Qualified Stock Options (NSOs): More flexible than ISOs but without the same tax advantages.
- Restricted Stock Units (RSUs): Represents a commitment to give shares or the cash equivalent in the future.
- Phantom Stock: Provides cash bonuses that mimic the value of stock but do not involve actual ownership.
- Stock Appreciation Rights (SARs): Offers the right to the increase in the value of a designated number of shares.
3. Vesting
Vesting is a crucial component of equity grants. It means that while the equity is granted upfront, the recipient earns the right to it over time. Common vesting schedules include:
- Cliff Vesting: A set period must pass before any equity vests. After the cliff, all or some portion of the equity vests at once.
- Graded or Linear Vesting: A certain percentage of the grant vests gradually over a specified period, e.g., 25% annually over four years.
- Milestone Vesting: Equity vests when specific company or individual performance milestones are reached.
4. Exercising the Equity
For stock options, there is a process called “exercising” where the recipient chooses to buy the shares at the predetermined strike price. This is only beneficial if the current market price is higher than the strike price.
5. Taxation
Equity grants come with tax implications, which vary depending on the type of grant, the country, and when you choose to exercise or sell:
- Stock Options: Generally taxed at the time of exercise (the difference between the strike price and the market price).
- RSUs: Usually taxed when they vest as they’re considered income.
6. Expiration and Termination
Equity grants, especially stock options, have an expiration date. If not exercised by this date, they become worthless. Moreover, leaving a company can impact the status of your equity, depending on the agreement terms.
7. Sale or Liquidation Event
If the company is sold or goes public, there are typically provisions in place for what happens to outstanding equity. This could mean a significant payday for those holding vested equity or options if the company sells for a value above the strike price of the options.
8. Documentation
Every equity grant is accompanied by detailed documentation outlining terms, conditions, and any restrictions. This includes the vesting schedule, exercise price for options, and what happens in various scenarios like a sale of the company or the departure of an employee.
In summary, equity grants are a way to align the interests of employees and other stakeholders with the long-term success of the company. They can be a valuable tool for both attracting and retaining talent, especially in competitive sectors. However, they come with complexities, especially around taxation and vesting, that recipients should be aware of. It’s often advised to consult with financial or legal professionals when navigating the world of equity grants.
How equity grants benefit startup founders and employees
For startup founders, equity grants:
- Help conserve cash by offering compensation beyond a salary.
- Align the long-term interests of employees and founders.
- Enhance company loyalty and retention.
For employees:
- They offer the potential for significant financial gain if the company succeeds.
- Represent a sense of ownership in the company.
- Foster a longer-term commitment to the organization.
Equity incentive plan as a talent acquisition and retention tool
Companies, especially startups, often compete for top talent. An equity incentive plan can be a major draw for potential hires. Offering equity can:
- Differentiate a company from competitors.
- Provide an additional form of compensation.
- Incentivize employees to work toward the company’s success.
What is an equity grant agreement?
It’s a formal document detailing the terms and conditions under which equity is granted. This might include vesting schedules, exercise price, and the type of equity being granted.
How does an equity grant work for employees?
Employees are given the right, but not the obligation, to purchase or receive shares at a predetermined price or under certain conditions. Over time, as these grants “vest”, they can be exercised, allowing the employee to benefit from the company’s growth.
Will the Equity Grant be Given Under an Employee Plan?
Most equity grants are given under an established employee equity incentive plan, which outlines the total number of shares that can be granted and other specifics.
What Type of Equity Grant Will I Receive?
There are several types, including:
- Employee Stock Options (ESO)
- Incentive Stock Options (ISO)
- Non-qualified Stock Options (NSO)
- Restricted Stock Units (RSU)
- Phantom or Virtual Stock Options
Each has its unique characteristics and tax implications.
How Do Securities Laws Apply to my Equity Grant?
Securities laws ensure that equity grants and stock sales are conducted fairly and transparently. It’s vital to ensure that your company’s equity grants comply with these regulations, often requiring proper documentation and sometimes registration with regulatory bodies.
Will the Equity Vest?
Most equity grants come with a vesting schedule. Vesting means that while you’re granted the equity upfront, you earn the right to it over time, often several years.
How Much Equity Will I Receive?
The amount varies depending on your role, the company’s stage, and negotiation. Typically, earlier employees and key roles may receive larger grants.
When Does the Grant Expire or Terminate?
Each grant has an expiration date, post which the right to exercise it disappears. This is often several years after the grant is made but can be sooner upon events like leaving the company.
How Are Equity Grants Taxed?
Taxation depends on the type of grant and when you choose to exercise it. It’s essential to consult with a tax professional to understand specific implications.
What are the types of equity grant
- Employee Stock Options (ESO): Contracts between the employee and employer, granting the right to buy the company’s stock at a set price within a specific timeframe.
- Incentive Stock Options (ISO): These are a type of ESO that provides tax advantages for the recipient, but with stricter regulations.
- Non-qualified Stock Options (NSO): Unlike ISOs, NSOs are taxed at regular income rates upon exercise, but they have fewer restrictions.
- Restricted Stock Units (RSU): Represent a promise to give the recipient shares or the cash equivalent of those shares in the future.
- Phantom or Virtual Stock Options: These mirror stock options but provide cash bonuses based on stock’s value, rather than the stock itself.
Equity grants are an integral part of the modern compensation landscape. It’s essential to understand their nuances, both as a company owner and as an employee, to maximize their benefits.
