Employee Equity 101

One of the most important issues associated with any startup is employee equity. Most employees join a startup with an expectation of receiving some amount of equity in the company. Employee equity aligns the entire startup team, as everyone looks forward to his/her payday once the venture is ultimately successful. The vast majority of venture capital term sheets will stipulate either the creation of, or replenishment of, an Employee Stock Option Plan (ESOP). A typical ESOP pool is 15% of total equity outstanding, but this number can move as high as 20% and as low as 5%, depending on the company/stage/etc.

Most people immediately think of Stock Options when the topic of employee equity arises, however, there are other variations of equity based compensation.

Stock Options give an employee the right to purchase a share of common stock at some point in the future. The Stock Option is issued with a ‘strike price’, i.e. the price the employee must pay to buy one share of common stock. An option is ‘in the money’ if the current trading price per share of common stock is higher than the strike price per share- in which case the employee will exercise his/her option to buy the common stock, and realize income on the strike price / trading price arbitrage.

Another form of employee equity compensation is Restricted Stock. Unlike a Stock Option, if an employee is granted Restricted Stock, he/she actually owns a share of the company from the date the Restricted Stock is issued. However, there are rights restrictions related to when the employee can sell the stock, and there are tax implications that do not arise with stock options (i.e. income tax upon the grant of the restricted stock, and capital gains tax upon the eventual sale of the restricted stock).

Another form of employee equity compensation is a profits interest. Under this scenario, an employee receives a proportional interest in any profits the company generates (cash-flow from operations, an acquisition, an IPO, whatever). From a tax standpoint, the employee will generally will not have taxable income upon his/her receipt of pure a profits interest because the interest will have no value as of the date it is issued (by definition). An additional benefit of profits interests is that the employee does not need to fund an exercise price, as with a Stock Option.

One final option, is the use of Phantom Equity. Also known as “shadow” stock, this type of stock plan pays a cash award to an employee that equals a set number or fraction of company shares times the current share price. The amount of the award is usually tracked in the form of hypothetical units (known as “phantom” shares) which mimic the price of the stock. There are two main types of phantom stock plans. “Appreciation only” plans do not include the value of the actual underlying shares themselves, and may only pay out the value of any increase in the company stock price over a certain period of time that begins on the date the plan is granted. “Full value” plans pay both the value of the underlying stock as well as any appreciation. Phantom stock plans can appeal to employers and employees for several reasons. As an example, employers can use them to reward employees without having to shift a portion of ownership to their participants. Employees receive compensation that does not require a cash outlay of any kind (tax or strike price) and also does not cause them to become overweight with company stock in their investment portfolios.

Hopefully that’s a helpful primer on a few common forms of employee equity compensation. Employee equity can be a complicated topic. Entrepreneurs can cost themselves large amounts of exit value, and employees can be confused by what they’re actually receiving as part of their comp package. If structured correctly, employee equity compensation plans can dramatically motivate a team, which in turn provides accretive enterprise value far in excess of the 15% (or so) equity stake that has been ‘given’ to employees.