The Pareto Guide To Issuing Employee Equity

by Leo in August 15th, 2021
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Often comprising 10-40% of compensation at early-stage startups, equity is a key component to employee hiring. 

Therefore, founders must take care in establishing an equity incentive plan, a standard document drafted by a company’s legal counsel that permits a company to grant equity to its employees. 

Once the plan is set up, the next step is to issue equity to employees - a process involving several key actions your company must take to do so correctly and compliantly.

How does this actually work? 

In short, when making your first hire, you’ll typically:

  • Determine how much equity to give the new employee
  • Issue a Board Consent, a written document indicating approval from your company’s Board of Directors, authorizing the shares issuance
  • Execute a stock purchase agreement with your employee, transferring ownership of the stock from your company to him or her
  • Update your cap table, a table showing records of ownership in your company, to include your employee’s shares

Read below for more details on each step.

Glossary

  • Board Consent: An approval by a company’s Board of Directors, often in written form
  • Stock Purchase Agreement: A contract transferring ownership of a company’s stock to the purchaser
  • Cap Table: A table showing a record of ownership in a company
  • Fair Market Value: The price of an asset under normal market conditions. In the case of startup equity, often determined by a 409a valuation
  • 409a Valuation: An independent appraisal of a private company’s stock
  • 83(b) Election: A letter sent to the Internal Revenue Service (IRS) electing for taxation on equity on the date of grant vs. date of vesting

How do I issue shares to my employees?

Step 1: Agree on amount of equity to issue to the new employee

First, let’s start with the obvious: agree on the amount of equity to be issued to the new employee. 

Considerations on total compensation aside, it’s important to understand that employees receive shares from the employee option pool.

This involves setting aside a portion of your company’s shares for all current and future employees, and then allocating shares from the pool to new joiners of the company.

Note: A typical size for the employee option pool ranges from 10-20% (from Holloway Guide To Equity Compensation) of the company’s stock, with earlier-stage companies falling on the lower end of the range. However, as pools are usually refreshed after each funding round, a current pool will only have to last until the next round and in the event that the pool runs out, the Board can also create a new pool - albeit with dilution for all shareholders.

Step 2: Authorize employee share issuance via Board Consent

Next, once the amount of equity to issue to a set of new employees has been decided, the Board Consent formalizes the issuance.

Here, the company’s Board of Directors votes to approve this grant, and also determines the fair market value (FMV) of the shares. If the company has already completed a 409a valuation, the FMV would take on that valuation’s price per share; however, if the company has never done a 409a, the value will be determined by the Board.

Now you may be wondering, how often should the Board do consents?

It’s very rare to do Board Consents after every new hire - oftentimes, it may be more efficient to approve the issuances for multiple employees in one go. Companies can save time in batching the consents over doing one for each employee, and also save on legal fees. 

Note: This is especially true as Board Consents can be back-dated to when the employees originally started at the company, thus staying in-line with employee shares vesting. The only time it makes sense to time a Board Consent is if there is an event that may meaningfully change the company’s valuation, such as a fundraising round or 409a valuation.

Step 3: Issue Stock Purchase Agreement to employee

With the issuance now authorized, it’s time to grant shares to your employees. 

This is typically done by issuing a Common Stock Purchase Agreement (also known as a Restricted SPA) to the employee, outlining the terms of the sale of stock to the employee, such as purchase price and number of shares. The agreement may also contain information such as certain rights the company may have on the employees’ shares.

Note: Oftentimes, the employee will submit a cash payment to the company in exchange for the shares; however, an early employee may not be required to purchase the shares depending on the price per share and number of shares granted, instead being granted the shares for “services performed” - allowing the shares to be granted and considered income (and the value of the shares will be taxed as such). This is especially true if the company has a high share price and the employee may not be able to pay the full amount.

In addition, the agreement will also provide the employee an option to make an election pursuant to Section 83(b), or 83b election.

While this article will not go into detail on the pros and cons of such an election, the main takeaway is that an 83b election enables the payment of income tax on the equity on the date of the grant versus the date the equity vests, potentially lowering the tax burden.

Step 4: Add employee shares to cap table

With the shares now officially owned by the employee, the last action item is to reflect this change in ownership in your company’s cap table.

Cap table management software, such as Pulley, can help with tracking your company’s equity - the days of maintaining everything in a spreadsheet are now over.

What are some best practices when issuing shares to my employees?

Here are a few additional items to note when it comes to employee equity:

  • Types of grants - there are various types of equity grants, such as ISOs (incentive stock options), RSUs (restricted stock units), and, most common in early-stage startups, simply restricted stock
  • Vesting schedules - employees do not immediately own all of the shares issued to them; ownership is obtained following vesting, with a typical vesting period of 4 years with an initial 1-year cliff
  • This means an employee receives 25% of his/her shares after 1 year of service, with a portion of the remaining shares vesting each month afterwards over the course of the remaining three years of the grant
  • Company rights to employee shares - in addition to vesting schedules, employee shares may also be subject to limitations on transfer (such as right of first refusal) or lock-ups post-IPO

Lastly, it’s important to point out that employees may face risks when it comes to their equity - if a company is no longer in business, an employee could lose all of the money originally spent to purchase their shares.

In summary…

Issuing equity to your startup's employees is a process, but it doesn't have to be complicated. 

By following the steps above, you'll know what to do and when to take these actions - the business choices you, as a founder, have to make.

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Note: Our content is for general information purposes only. AbstractOps does not provide legal, accounting, or certified expert advice. Consult a lawyer, CPA, or other professional for such services.

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