Granting equity in early-stage companies is a critical decision that can shape the future of your business. It plays a key role in driving growth, building a positive company culture, and securing long-term success. At Keough Law, PLLC in Orlando, Florida, we offer tailored guidance to help startups understand equity distribution.
Equity grants are powerful tools for attracting talent, retaining employees, and encouraging a sense of ownership. However, they must be handled carefully to avoid potential conflicts or imbalances. Understanding how to properly grant equity lays the groundwork for a strong, thriving business. Let’s look at how business law factors into these important decisions.
The Basics of Granting Equity in Startups
When a new business is formed, the founders typically own the initial equity. As the company grows, it may offer additional equity to attract talent or secure investments. Equity can take many forms, such as stock options, restricted stock units (RSUs), or outright stock grants. The structure you choose depends on your goals, the stage of your company, and the people.
Equity grants serve several purposes, including:
Attracting talent: High-quality talent is essential for any company’s growth, and offering equity can be a persuasive way to lure skilled individuals who might otherwise be hesitant to join a new company.
Retaining employees: Equity can also serve as a retention tool, giving employees a reason to stay invested in the company's success long-term.
Motivating founders and employees: Offering equity creates an incentive for employees to think and act like owners, aligning their interests with the company’s success.
Attracting investors: Investors often want to see that the founding team has “skin in the game.” Having equity in the company shows commitment and can reassure potential investors.
While equity grants can certainly offer great benefits, they must be handled carefully and with foresight. A business law professional has the insight to help. Here’s a look at the different considerations to keep in mind when granting equity in early-stage companies.
Determining How Much Equity to Grant
Determining how much equity to give to employees, founders, and other stakeholders is an important decision. It requires balancing the need to incentivize individuals with the reality of ownership dilution. The more equity you grant, the less the founders or initial investors own in the company.
Some general rules of thumb include:
Founders: Founders generally receive the largest portion of equity. However, if there are multiple co-founders, the equity will need to be divided up between them. Founders typically retain 40-60% of the company, depending on the number of individuals involved.
Employees: As employees are crucial to building the company, they may receive stock options or equity as part of their compensation. Typically, early-stage companies reserve around 10-20% of the total equity for an employee stock option pool.
Investors: When seeking investors, equity is often offered in exchange for funding. The percentage granted depends on the valuation of the company and how much capital is being raised.
The specific amounts of equity granted can vary based on many factors, such as the role of the individual, the current stage of the company, and the amount of capital involved. Be prepared to make tough decisions about how much ownership to allocate to each party. When you need help with these decisions, it pays to contact a business law professional from our team.
Vesting Schedules: Protecting the Company's Long-Term Success
One of the key tools in equity grants is the vesting schedule. A vesting schedule is essentially a timeline over which an individual earns their equity.
For example, a four-year vesting schedule with a one-year cliff is common in early-stage companies. This means the employee won’t own any of their granted equity for the first year, but after one year, they’ll “vest” in 25% of the equity. After that, they’ll continue to vest in equal portions over the following three years.
Why does this matter?
Employee retention: A vesting schedule is designed to encourage employees to stay with the company. If they leave before their equity fully vests, they lose out on the portion of equity they haven’t earned.
Aligning incentives: Vesting aligns the interests of employees with the company. Employees who remain with the company long-term are more likely to see the value of their equity grow as the business succeeds.
Founders and key personnel: Founders may also want to vest their own equity over time, making sure they remain committed to the company. If they don’t vest their shares, they could walk away with a significant portion of equity without contributing to the company’s long-term success.
Vesting can be a great way to protect both the company and its stakeholders, encouraging commitment while safeguarding against potential issues with individuals who leave the company prematurely.
Employee Stock Options vs. Restricted Stock Units (RSUs)
When granting equity to employees, companies generally choose between stock options and restricted stock units (RSUs). Both have distinct benefits; understanding the difference can help you decide which is the best fit for your company.
Stock Options
How they work: Stock options give employees the right to purchase a set number of shares at a predetermined price within a specific timeframe. If the company grows in value, employees can exercise their options and buy shares at the lower exercise price, profiting from the increase in the stock’s value.
Pros: Employees have the potential to make money if the company’s value increases. Stock options can serve as a strong retention tool and help employees feel directly invested in the company's success.
Cons: If the company doesn’t grow as anticipated, stock options may lose their value, and employees may choose not to exercise them.
Restricted Stock Units (RSUs)
How they work: RSUs are units of stock that are granted to employees but only vest after certain conditions are met (such as staying with the company for a certain number of years). Once vested, the employee owns the stock outright.
Pros: RSUs don’t require employees to purchase shares. Once vested, they represent actual ownership in the company. They can be a more attractive option for employees who may not have the financial resources to purchase stock options.
Cons: RSUs could result in a higher tax burden for employees when the units vest since they are considered taxable income when they are granted.
Both stock options and RSUs offer potential advantages, but the decision ultimately comes down to your company’s goals, the type of employee you’re looking to attract, and how you want to structure your equity offering.
Legal Considerations When Granting Equity
Granting equity isn’t just a financial matter; it’s also a legal one. Several factors must be taken into account to make sure that the equity distribution process is handled properly from a business law perspective.
Securities laws: When issuing equity, you must comply with securities laws. These laws regulate how companies can offer and sell securities to investors, including stock. Violating securities laws can lead to significant penalties, so it’s essential to have legal counsel review your equity offerings.
Shareholder agreements: If you’re issuing equity to investors or founders, a shareholder agreement is critical. This document sets forth the rights and responsibilities of shareholders, including voting rights, transfer restrictions, and how disputes will be resolved.
Tax implications: The tax treatment of equity can vary depending on the type of equity granted. For example, stock options and RSUs are treated differently under the Internal Revenue Code. It’s important to work with an accountant or tax attorney to understand the tax consequences of equity grants.
State laws: Equity offerings are also subject to state laws, which can vary depending on where your company is incorporated. For example, some states have specific rules regarding how equity can be issued, what kind of disclosures must be made, and how corporate governance must be structured.
Consulting with a business law attorney to review your equity grant plans can help you avoid common pitfalls and assure compliance with the applicable regulations.
Reach Out to Our Business Law OfficeToday
If you need assistance in Orlando, Florida or the surrounding areas, including Orange County, Osceola County, Hillsborough County, and Pinellas County, our firm is here to help. Reach out to Keough Law, PLLC today to discuss how our decades of business law experience can support your business’s growth.
