Top 10 Frequently Asked Questions About Equity Compensation
Options. Stock. Equity. Vesting. Sweat Equity. These are just a few of the concepts that are part of a startup’s toolbox for building a team and which generally fit within the broader category called “equity compensation.” It is essential for a company’s cap table and the rights and restrictions associated with the securities listed on the cap table to be properly documented, compliant with securities and tax laws (including certain time sensitive filings), and granted pursuant to proper board approvals. While some startups may be tempted to take a DIY approach, the costs incurred with correcting any mistakes (both in terms of re-documentation and addressing investor diligence questions/concerns) often greatly exceeds the cost of having a lawyer do it correctly the first time. Here are ten common questions I receive from clients about issuing equity compensation to service providers:
What's the difference between options and stock?
An option is a contractual right to purchase a certain number of shares of stock (typically common stock) at a pre-agreed price (the exercise or strike price). If someone receives shares of stock, then that person holds a direct ownership interest in the company, along with certain stockholder rights.
Should I grant stock options or shares of stock?
It depends on a few considerations, a primary one being the value of a share of stock at the time of grant. If you award shares of common stock, then the value of such shares is taxable to the recipient at the time of grant. In contrast, if you grant stock options, then such options are not taxable to the recipient at the time of grant. There are different types of options (nonstatutory (also known as nonqualified) and incentive), each with different post-grant tax treatment. For a more in-depth article on this particular question, please check out this article.
Can LLCs grant stock options?
The short answer is yes, an LLC can grant nonstatutory options but not incentive options. LLCs can also take advantage of a type of equity, unique to LLCs taxed as partnerships, called “profits interests.” For a more in-depth article on this particular question, please check out this article.
I promised someone 5% equity in my company – do you (the lawyer) have what you need to start preparing the necessary documentation?
No. By “equity,” are you referring to options or shares of common stock? What are the vesting terms? What is the current value of your company and what is the strike price? Is there acceleration? Is there already some written documentation with the intended recipient that describes such promise? These are just a few of the follow-up questions I would ask you.
Will the service provider be subject to dilution?
Unless there’s a contractual agreement stating otherwise (which would be extremely uncommon, especially with respect to a service provider), then yes, an equity grant is subject to dilution. The board of directors can always decide at a later time to issue the service provider more equity.
Should the stock options or shares of stock be subject to vesting?
Generally, yes. If options or shares of stock are fully-vested at the time of grant, then I would worry about a situation where the service provider leaves the company early on and yet retains full ownership. With stock options, there is a post-termination exercise period (typically, three months but can be longer if granting a nonstatutory stock option), after which the option holder would lose his or her options if unexercised during such period.
How many stock options or shares of stock should I award?
It is important to understand what is “market” with respect to a particular type of service provider. Your attorney or other advisors can guide you on this question.
Do I need to make any government filings?
Maybe. Any issuance of equity is subject to a complex body of federal and state law, known as “securities law.” Here’s a useful article, which talks about securities law in the context of fundraising activities, but it does contain some pertinent background information.
What’s the process for granting equity?
A typical process:
- the service provider will enter into some form of service/employment contract, which includes a promise to grant a certain amount of options or stock (preferably expressed as a number of options/stock; not a percentage);
- the board of directors will then approve the agreed upon equity award;
- the legal professional will prepare the equity award agreement (e.g., a stock purchase agreement or an option agreement);
- you will then circulate for review and signature; and
- the paralegal will update the cap table and ledger.
This process of course assumes that a Stock Incentive Plan is already in existence. If not, those documents will need to be prepared and approved by the board and shareholders.
I already committed to certain equity compensation terms with a prospective service provider – should I have looped you (the lawyer) in sooner?
Yes. Before communicating the equity terms in writing, run the language by your attorney. Time/money spent upfront can save greater time and money down the road. Moreover, be careful with how you discuss potential equity awards with new hires. You want to avoid misunderstandings as well as possible tax complications. When onboarding someone, speak about the potential equity award in a conditional manner. For example, “If we enter into the consulting agreement, then upon board approval, the board will grant you the options and you will be asked to enter into an option agreement.”
Have more questions than I answered here? Please comment below, email me or connect with me on LinkedIn or Twitter.
The blog content should not be construed as legal advice.