What, precisely, is an equity incentive plan? In simple words, it is an effective strategy used to attract and retain top talent and reward the staff by giving them a fraction of equity in a startup. Companies frequently give shares or units to partners, directors, contractors, or other individuals as a form of compensation.
This article gives a general overview of some of the most significant elements of equity incentive schemes, including different incentive types for employees and the average share pool size.
Equity in a Startup–Staff Compensation
An equity incentive plan has two main goals:
(1) to motivate employees to perform better by sharing profit if the company grows, and
(2) to ensure the employees stay with the company by aligning their interests with those of the company.
Employees who participate in equity programs receive shares in the business they work for. Shares may be granted through bonds, stocks, warrants, or stock options. The most popular and well-known type of employee equity in a startup is stock options.
While businesses can issue shares to an employee without employing a proper equity incentive plan, a well-thought-out plan significantly lowers administrative costs and streamlines the procedure for each equity compensation grant. The company must also determine the number of shares set aside for an equity incentive scheme in advance.
A company’s share or option pool typically ranges from 5% to 20% of its fully diluted capitalization; mature companies work within the lower range.
Under a company’s equity incentive plan, various equity incentive awards may be given out. Equity incentive pay typically comes into two categories:
(1) the actual grant of an ownership stake in the company
(2) the award linked to the company’s valuation.
Actual Ownership Grants–Restricted Stock Awards and Options
The most frequent awards given under equity incentive plans are stock options and restricted stock awards.
Stock options are the most prevalent kind of equity incentive pay granted under equity incentive plans. An equity incentive plan is also referred to as a "stock option plan" for this reason.
There are two types of options: Incentive stock options (ISOs) and non-qualified stock options (NQSOs). Only employees technically qualify for ISOs, which also offer some tax benefits. NQSOs, on the other hand, may be provided to service providers other than employees. However, they do not enjoy the tax advantages of ISOs.
Restricted Stock Awards
A restricted stock award is a grant of business stock (known as a share) awarded to the employee on the grant date; they can exercise these shares only after the shares vest (or lapse in restrictions). The vesting period refers to the restricted period. An employee owns the shares outright once the vesting conditions are satisfied, at which point they can treat them just like any other share of stock in their portfolio.
An employee must choose whether to accept or reject a restricted stock award when it is issued. Depending on the type of equity in a startup, the employee might need to pay the employer a purchase price for the grant if he takes it.
Restricted Stock Units
Restricted stock units (or "RSUs") are an unfunded, unsecured commitment to receive a future share of the company’s stock. The RSU holder does not have any rights, such as voting or dividend rights, because shares are not actually issued on the grant date, unlike an RSA. RSUs can also be settled in cash or in shares with a value equal to the company’s stock.
An RSA is comparable to an RSU if it is settled in shares, even though the recipient does not become the beneficial owner until the settlement date.
RSUs are heavily tax-motivated and typically more appropriate for later-stage firms.
What is a vesting Period?
In simple terms, award recipients have to hold off until a specific deadline – vesting date – or set of performance standards – vesting conditions– are reached to avail their benefit of equity in a startup. Since this sort of payment is intended to serve as an incentive, there must be limitations to encourage employees to continue working for the business, contribute to its success, and benefit from its growth.
Grants Linked to the Company’s Valuation
These awards include stock appreciation rights and phantom stocks. Also, depending on the settlement mechanism used for RSUs, they can either be considered equivalent to stock appreciation rights (if the shares are settled in cash) or otherwise equivalent to RSAs (if the equity in a startup is granted).
Phantom stocks are RSUs that can only be paid in cash. Although phantom stocks can be awarded through equity incentive plans, most companies use a distinct phantom stock plan.
Rights to Stock Appreciation
The holder of stock appreciation rights is entitled to receive benefits equivalent to the increase in the value of the underlying shares. Stock appreciation rights are typically settled in cash, although they may also be settled in shares, cash, a combination of stock and money, or another asset.
Depending on the intended award and other factors, the organisation will determine the kind of award a particular employee receives. Options and RSAs are used frequently in early-stage firms since they are easier to manage. Other award kinds with more complicated administrative, tax, accounting, and corporate governance challenges than options and RSAs may be introduced as a firm develops.
Employees that get early access to a company’s equity should stand to benefit from the company’s long-term FMV growth. On the other hand, equity incentive awards can benefit early-stage startups by saving upfront costs for paying top wages and incentives to recruit and retain the talent they need to thrive.
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