In a conversation recently, an experienced private equity lawyer told me “Mike, you must have teeth as well as balls!” I liked her metaphor and it was a good reminder when thinking about taking shares as fees in a company you’re working for. In the end I took the equity: but that’s another story (and what makes Who Needs Law a little different!)
It got me thinking more generally about company equity, in this series of blogs I’ll try to cover some equity topics that high-growth companies may encounter, starting with equity incentive structures.
A few points to remember
Equity is Earned – Unlike investors, those working in or for the company normally take equity subject to a vesting schedule, effectively earning shares as they go. In some cases vesting is accelerated, for example if a founder contributes pre-existing IP to the business or has been working on the project for significant time prior to incorporation.
Vesting Periods – As a rule of thumb, vesting periods start at four years for employees and vary (downwards) for other key people according to their importance. Companies often include protections to prevent shares ending up in the wrong hands, including “cliffs” which delay vesting until after a probationary period and “bad leaver” restrictions which cancel all or part of the vested shares where an employee leaves on bad terms. Founders, senior employees, directors, all sometimes negotiate for a portion of the vesting accelerates if the company changes control.
Shareholdings Dilute on New Investment – Those holding shares or options should remember their percentage will dilute when new shares are offered to investors. Although anti-dilution terms are possible, it is unusual to find this in employee share schemes. The usual adage is that equity investment is normally positive for company growth and therefore existing equity holders are glad to have a slightly smaller share of a much larger pie.
Preparation for Future Investment – Looking to the future towards preparation for VC investment, generally if equity incentive schemes are reasonable, VC firms will leave them in place. It is common however to ask founders to top up allocation to option pools pre money: essentially VC’s aim to invest fully diluted including a full option pool up to the agreed percentage. Founders should look carefully before accepting pre-money option pool top ups because it eats into founder equity and reverse dilution (i.e. cancellation of un-issued/vested shares) on future sale disproportionately impacts founders. Practical tips, founders should ensure option pools are the smallest possible and check they completely understand the pre/post money equity distribution and put the option pool in th post money if you can.
What’s Reasonable Distribution for Equity Incentive – It varies of course! Below is a rough example (but note that it’s not a bell curve): Title Range (%)
- CEO: 5 – 10
- COO: 2 – 5
- VP: 1 – 2
- Independent Board Member: 1
- Director: 0.4 – 1.25
- Lead Engineer: 0.5 – 1
- 5+ years experience Engineer: 0.33 – 0.66
- Manager or Junior Engineer: 0.2 – 0.33
Legal Structuring – Normally equity incentives are given via share options or share grants. There are important legal and tax differences between the two, for the company and equity holder. Companies should check their constitutional documents and any shareholder agreements allow the share scheme. The share scheme itself will need to be documented and may also require approval from tax authorities, particularly if tax benefits are sought, see below. Equity holders should remember that a share option is only a contract with the company not physical shares, and this can have important consequences, for example in the event of a dispute.
Tax Structuring – Most countries enable companies to structure equity incentive schemes tax efficiently. Companies need to keep in mind the tax consequences of different equity structures, for example they may need to account for option values in profit and loss account from the date of grant. As well as speaking to a professional tax advisor, Companies can check with their local tax authority and also the Employee Share Ownership Centre (www.esopcentre.com) ( a non-profit organization specializing in employee share ownership plans in the UK and Europe).
Equity is a great way for companies to incentivise and reward key people and for those people to acquire a stake and (potentially!) accumulate wealth. Beware though, the value of equity may not always go up.
Who Needs Law can assist you in structuring your share incentive scheme.