What The L || What the Law: The Legal Basics of Equity Compensation
By Charlotte Teal and Kwang Lim
Start-up companies face the ultimate dilemma: how to compensate, incentivize, and retain quality employees at a time when (most) start-ups are strapped for cash and consequently unable to compete with the higher salaries often offered to, and expected by, top tier employees. While not necessarily intended to replace employees’ salaries, equity compensation programs are tools that can help recruit, retain, and incentivize employees to take a chance (and likely a pay cut) at a startup company. Employee interests, however, need to be balanced with shareholder and investor interests; these are not always aligned.
This blog post is meant to provide a preliminary introduction into the world of equity compensation programs and help you consider whether an equity compensation program is right for your company.
What is Equity Compensation?
Equity compensation is used as an inventive tool to align employee interests with the growth objectives of the company. By granting equity to employees, the company grants its employees rights to securities linked to the value of the company.
There are various types of equity compensation. Equity compensation packages are not “one size fits all”, and the appropriate type of compensation will depend on the circumstances and objectives of each individual company. This blog post will not go into detail, however as a brief introduction, some of the types of equity grants available are:
1. Share Grants:
Employees are issued shares as they join the company or gradually over time.
2. Stock Options:
Employees have a contractual right to purchase shares at a specified price (typically fair market value at the time the option is granted) for a set period of time.
3. Restrictive Share Units (RSUs):
Employees have a contingent right to receive shares or a cash equivalent to the value of the shares, based on reaching certain future dates or milestones and continued employment.
4. Deferred Share Units (DSUs):
Like RSUs, employees have a contingent right to receive shares or a cash equivalent of the shares, however the award does not vest until death, termination of employment, or retirement.
5. Share Appreciation Rights (SARs)
Employees have a right to receive a payment in cash or shares that represents the increase in value of the shares of the company, calculated over a defined vesting period.
6. Phantom Share Plans:
Employees do not get actual shares, but get an interest in the company that is linked to the shares; employees receive an account with a specified number of phantom (hypothetical) shares.
Why Consider Equity Compensation?
Equity compensation can have many benefits, including:
- Helping cash-strapped companies conserve cash for other expenses.
- Helping a company recruit talented employees by offering them the opportunity to participate in the potential upside of the company’s success.
- Incentivizing employees to work hard by aligning an employee’s goals with those of the company, as their opportunity to profit depends on the success of the company.
- Helping a company retain employees and avoid high turnover as employees’ equity rights are often subject to vesting schedules, meaning that an employee cannot acquire the equity (or cash, depending on the type of compensation program) until a specified date.
However, while there are benefits, there are also costs to implementing equity compensation:
- Awarding equity compensation engages various areas of law, and companies will need to familiarize themselves with the legal requirements and legal consequences.
- Depending on the type of equity granted (for example, if shares are granted to employees), the company will, to a certain extent, democratize ownership, which can impact how a company is run and can impact investor interests.
- As equity compensation structures will have tax implications for the company and the employees, a company should be prepared to consult with a tax lawyer.
- If it is likely that the company will eventually be sold, equity compensation programs can make merger and acquisition transactions more complex. In addition, if the company is planning to go public in the future, the legal requirements of the relevant stock exchange ought to be considered.
Equity compensation programs can be a great tool for start-up companies to attract, retain, and incentivize employees. However, they are notably complex and must be carefully considered. Companies should consider how they plan to compensate their employees early, before recruiting key employees and executive members.
The views and comments expressed in this blog post are those of the authors and do not represent the views of Bennett Jones LLP. This blog was prepared for informational purposes only, and should not in any way be construed as legal advice. Entrepreneurs and companies contemplating financing should seek legal advice. If you are considering offering equity compensation to your employees, Bennett Jones would be pleased to help you determine which option is best for your company.
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