By Nikki Piplani and Joe Wallin
If you are a startup company founder, one of the first questions you will have will be about sharing equity with your early hires. Once you start asking, you will hear plenty of advice about this.
You will hear— “Be generous”. You will also hear— “Worry about dilution”. The concerns around dilution are fair, but you do need to form a team, and if you are a very early stage startup, your most powerful incentive, aside from an interesting problem to solve, is a generous equity offer.
Immediately after the issuance of the founders’ shares, the general consensus seems to be to reserve between 15- 30% of the issued and outstanding shares in a stock incentive plan for your key hires. (Meaning, if you have issued 4M shares to your founders you would set aside about 600,000 shares in the stock option or stock incentive pool.)
But beyond reserving some amount of shares in a stock incentive plan, there are still plenty of questions to work through.
“Is there a right or suggested amount of equity for the positions startups typically want to fill?”
“Is there a published schedule somewhere, where I can read about what to give out in equity to my early hires, and that shows how this changes as my startup matures? Sort of like what you see on the Founder’s Institute Fast Form site for advisory board members?”
“Or is hiring and sharing equity something that varies so much depending on the particular facts that no industry standards or guidelines exist?”
And then, “Once I find out the number of shares to give someone, from a legal and tax point of view, what do I need to think about?”
And finally, “How do I document this all correctly so as to not step off some unknown legal or tax ledge where I hurt myself, my company, or the person I was trying to incentive with the equity award in the first place?”
Based on our experience navigating these questions, we’ve put together a brief guide for helping you think through the process.
How Many Shares?
Unfortunately, determining exactly how much equity to grant to your early team is not easy. There are no scheduled or published guidelines. It is all very fact specific.
As Sam Altman said in a recent blog post, “It’s very difficult to put precise numbers on this because the specifics of every situation matter so much.” http://blog.samaltman.com/employee-equity . Information is scattered and may be hard to find, but there is some data out there on how many shares to issue to members of the team. Quora.com and blogs like AVC.com are good places to start. Again, Sam Altman’s recent blog post is helpful. Here is what Sam says:
“I think a company ought to be giving at least 10% in total to the first 10 employees, 5% to the next 20, and 5% to the next 50.”
Calculating the Actual Number of Shares
A lot of people get confused on this point. Truth is, there are a lot of different ways to take a given percentage and translate it into an actual number of shares. For instance, you can calculate the number of shares based on:
- The corporation’s issued shares outstanding shares
- The corporation’s issued and outstanding shares plus the number of shares already covered by stock options that have been granted
- The corporation’s issued and outstanding plus the corporation’s entire stock option or stock incentive pool
(By the way, you never translate a percentage interest into a number of shares based on the corporation’s authorized shares; that number is made up. What matters are how many shares are actually issued.)
What if your company has already issued a Series Seed or Series A? Do you count those toward the percentage?
The most important thing to do in translating a percentage into an actual number of shares is to do it in a way that can be easily and transparently described by you to your new hires.
Here is how you do this calculation:
A percentage is translated into a number of shares based on the issued and outstanding shares (not authorized!), on a fully diluted basis, but not taking into account convertible debt and convertible equity that will convert to shares on the closing of the next round.
The fully diluted share count includes:
- All issued and outstanding common shares;
- All issued and outstanding preferred shares;
- All of the shares in the equity plan; and
- Sometimes the shares underlying any outstanding warrants (this depends on the characteristics of the warrants; whether they are warrants to purchase shares on the next financing whose share impact can’t yet be calculated or whether their dilutive impact is already understood and baked into the cap table ).
Convertible notes or convertible equity that are waiting to convert to shares on the next fixed price round are usually left out. The reason? It is hard to know how many shares will be issued for these instruments. Plus, the award recipients and the founders will equally be diluted in the next round. It makes sense that your award recipients would incur the same dilution on the next financing as the founders.
Another reason to include the entire pool (rather than just the number of shares that are covered by currently issued awards under the plan) is for ease of calculation.
(For another reference on this point, see this article by Matthew Bartus : https://www.cooleygo.com/option-grants-fully-diluted-issued-outstanding/)
Let’s say you’ve settled on a 2% option grant for a new hire. How do you translate that 2% into an actual number of shares?
Your corporation will probably have a pretty big number of “authorized” shares. For example, you might have 20M total shares authorized. But, you might have only issued your founders 4M in total, and set aside in an option plan 600,000 shares. In this example then, your fully diluted share number would be 4.6M. How do you calculate 2% in this scenario?
You calculate the 2% based on the issued and oustanding common plus the entire pool. So you multiply 2% times 4.6M.
The main reasons to include the entire pool (rather than just the number of shares that are covered by awards under the plan) are: (i) ease of calculation, (ii) for the sake of consistency – this is how percentages of start-ups are typically calculated (e.g., this is how an angel or VC investor does this calculation), and (iii) this way the next person you grant options to you can use the same method of calculation and 2% in the next grant will result in the same number of shares.
Of course, if your new team members have questions on how you calculated the number of shares, tell them how you did it. Forthrightness in this area is important.
Your new team members might ask—”But won’t I be diluted in the future?” And the answer is— “Yes, all of us will.” This is the way it is in startup land.
What Type of Award?
Once you have decided on how much equity to give to someone, the next question is—what type of award should you give this person? There are really on a couple of choices in startup land:
- Stock Options; and
- Restricted Stock Awards
Bigger companies sometimes use RSUs. A good example of this is a company like Twitter, when it was ramping up to its IPO. It was using RSUs by this time. There comes a time in a startup’s life when RSUs start to maybe make sense, but not at the outset of the company’s life. At the outset, the way to go is either stock options or restricted stock awards.
Restricted stock awards, however, are really only helpful when the value of the company is really, really low. Like right at the start of a company. The reason? Taxes. Once a company’s value has become say, a quarter of a million dollars or more, award recipients either won’t be able to afford or not want to pay the income and employment taxes on stock awards.
For example, say you want to give an early developer 5%. If your company is worth $250,000, 5% of $250,000 is $12,500. This is $12,500 of taxable income. The taxes, counting employment taxes, will be several thousand dollars. Many people would rather not come out of pocket several thousand dollars to receive an illiquid stock award.
When this happens, you will then have moved into the zone where stock options are the only type of equity award that makes sense for the time being.
The Two Types of Stock Options
There are two types of stock options:
- nonqualified or nonstatutory stock options (NQOs); and
- statutory or incentive stock options (ISOs).
Only employees can receive ISOs. So independent contractors and directors who are not employees must receive NQOs.
ISOs can be more valuable to employees. But ISOs are more complex than NQOs to explain and administer. The exercise of ISOs can give rise to complex Alternative Minimum Tax consequences. Plus the company loses a tax deduction on an ISO. These are all reasons to keep your life simple and just grant NQOs across the board.
How to Document the Offer in an Offer Letter
This is another place where companies make mistakes.
Your offer letter should always say the equity grant is subject to board approval. This is not only a good practice but a requirement because an equity award is not legally granted unless the board approves. It is also smart because what if the board doesn’t approve? Or what if your optionees suddenly quits the company under unfriendly or hostile circumstances?
Example offer letter languge:
“Subject to the approval of the Company’s Board of Directors, you will be granted an option to purchase _____ shares of Company common stock under the Company’s stock option plan at an exercise price equal to the fair market value of that stock on your option grant date. Your option will vest over a period of four years, and will be subject to the terms and conditions of the Company’s stock option plan and standard form of stock option agreement, which you will be required to sign as a condition of receiving the option.”
In the offer letter, do not refer to a percentage. You have to specify the actual number of shares covered by the award.
Once you offer someone a percentage you have entered into the unknown. As explained above, there are many different ways to translate a percentage interest into an actual number of shares. You don’t want a dispute over that. Put in a hard number. You can explain to the optionee the summary cap table so that they can understand how the percentage interest can be calculated.
Is there a checklist of all the paperwork required?
Prior to Granting Stock Options or Restricted Stock Awards:
First, work with a lawyer to prepare a plan and the standard award agreements under the plan. Work with your lawyer to make sure that the board and shareholders adopt the plan in accordance with state corporate law. If shareholders do not approve the plan, you cannot grant ISOs, and you may be required to make additional, special filings with state securities regulators.
Grant all of your awards under the plan-If you are granting awards outside of your plan, you may not have a securities law exemption for the issuance of the award. This is the kind of mistake that can cost a lot of money to fix later. So, make sure you comply with the law in this area. There is a reason everyone adopts a plan and grants awards under the plan. The reason is that the path to compliance with the securities laws is easier and much less expensive with a board and shareholder approved plan than with other alternatives.
Make sure all of your awards are approved in unanimously executed Board Consents or appropriately documented in minutes of correctly noticed and called board meetings at which a quorum of directors was present. Again, work with your lawyer to make sure this is done right. If you do not do this right fixing it can be extremely expensive.
Confirm that you have sufficient shares in your plan to cover the award – Prior to granting awards, confirm you have the number of shares under the plan to grant the new batch of awards.
Rule 701- Before every grant of awards, confirm that you are compliant with Rule 701′s mathematical limitations. Rule 701 has mathematical limitations, meaning–there is a limit to the number of securities you can issue under Rule 701, and you do not want to exceed that limit. For a summary of these limits, see Rule 701: http://thestartuplawblog.com/rule-701/
Prospectus– If you have granted more than $5M in awards during the last 12 months, make sure to provide the prospectus required by Rule 701.
Eligible recipients– Confirm each prospective award recipient is eligible under the plan. Generally, only individuals qualify. Non-employee consultants can qualify as long as they are natural persons providing bona fide services and not receiving the options in connection with a capital raising transaction.
Confirm the residency of recipients – Before every grant of stock options, confirm the residency of the prospective award recipients and confirm that you are compliant with the Blue Sky law of each state in which the award recipients are resident.
If you are granting options to optionees in California, special attention will need to be given to California’s requirements. In California you have to file a form and pay a fee to grant stock options. The same goes for New York State, where you actually have to apply to the Attorney General for an exemption to grant stock options.
Fair market value- Make sure that options are being granted at fair market value in compliance with Section 409A of the Internal Revenue Code.
Board approval– Have the Board approve the option grants pursuant to a Board Consent or resolutions adopted at a meeting. If the vesting schedules for any of the options are different from the standard specified in the standard agreements, make sure the Board consent describes the vesting schedule.
Signed agreements– After each grant of an award, give each recipient a copy of the plan and their award agreements, and have them sign the agreements required under the plan.
Capitalization ledger– Update the capitalization ledger once the option is approved.
There are guidelines in this area, but this is also a complex area of your startup. With equity compensation you hit all the hard issues:
- How much equity will you share to incentivize key hires;
- How will you explain it to them so that they understand it and fully appreciate the incentive (after all, how much is an incentive worth if not understood?)
- And then of course there are all of the legal and tax complexities on top of that.
To make things easier on yourself, It makes sense to follow industry standard practices as much as possible. And don’t try to tackle this one without a lawyer. The legal details are really important in this area, so make sure you get good advice. Good luck!