Things to Keep In Mind Before Offering Equity Compensation

As a startup founder, you are almost always looking to hire dedicated, passionate, and devoted employees. Offering equity compensation is an excellent way to build a team that is aligned with your company’s vision and goals. As new startups bloom every year, the race to capture top talent has become more competitive than ever before. This is one of the reasons why many startups offer equity-based compensation to employees instead of cash.

While this approach offers its share of benefits, some challenges come along with it. If you look at it from a financial standpoint, equity compensation has accounting and high-level tax ramifications.

Hence, as a founder, you are likely to rack your brains to evaluate whether offering equity compensation is the right way to go for your business. In this article, we will take a look at a few things a startup founder should keep in mind before offering equity-based compensation.

Offering Equity Compensation: What Does it Mean?

When you decide to offer equity compensation to your employees, you are giving them partial ownership of your company. In this case, employees own a certain percentage of the total value of the company. In the U.S., this practice is also called offering stock options. As mentioned above, there are pros and cons associated with equity-based compensation.

Before you decide to give away a certain percentage of your company, it may be a good idea to understand the good, bad, and ugly sides of equity compensation.

Salary vs Equity

When employees receive a salary, a fixed amount is credited to their account for the number of hours they have worked. Equity largely means a percentage of a company offered to an employee based on the company’s total worth.

How Do Startups Leverage Equity Compensation?

Equity compensation is referred to as employee equity. In this scenario, a small part of the company is offered to employees in addition to their salary as compensation for their expertise. This approach is primarily deployed to make up for the below-market pay offered by companies.

Typically, offering equity compensation is more prominent among startups rather than established business entities. An early-stage startup founder is likely to lean toward this practice instead of paying a larger salary package without any equity since they are operating on a tight budget.

Advantages of Equity Compensation

• Acquire and Retain Dedicated Employees

Offering equity-based ownership is a tried, tested, and proven way to attract the best talent to work for you. It promotes loyalty and ensures your employees work toward the business’s success without ulterior motives. In addition, when your employees have some equity under their belt, their mindset is to stay for the long term.

• Financial Stability

This typically applies to early-stage startups that operate on a tight budget. When you offer equity, you are shelling out less capital to pay salaries. This also means that with this train of thought, startups will refrain from hiring someone who is looking to cash out at their expense, reducing the need to raise funds immediately.

• Tax Benefits

When employees accept equity, they can avail the taxable employment benefit. This benefit is at par with the difference between the fair market value of the shares when the employee purchased them and the amount paid for them.

Disadvantages of Equity Compensation

• Complicated Nature of Equity Compensation

There is no hiding away from the fact that equity grants or compensation are not very straightforward. There is plenty of nitty-gritty involved, which could leave you stranded. You need to constantly stay in touch with your legal team to ensure you are complying with anti-fraudulent laws. Further, you would also need the expertise of a tax attorney to take care of intricate and complex tax implications.

• Trouble While Selling Your Startup

When you give away a slice of your company, you may face some challenges while selling your startup. This is because interested buyers would want to purchase 100% of the company. When you decide to sell your company to a suitable buyer, if an equity-holder does not accept the terms, you are in for an unwanted tiff. On a similar note, since employee shares are worthless before an IPO or until the company is sold, they may strong-arm you into selling your business when you have no plans to do so.

• Privacy Concerns

Having multiple shareholders in your company will lead to decreased privacy. There is a high chance you may have to let the equity holders explore your books openly.

After going through the pros and cons of equity-based compensation, you need to make some critical decisions that will define the course of your startup.

Key Things to Keep In Mind While Offering Equity

Let’s take a look at some of the things companies need to do when they decide to offer equity compensation.

• Stock Option Pool

A founder should have a clear understanding of how much equity they wish to give to their employees. It is very important to create a stock option pool to keep tabs on the number of shares you can give away while hiring new employees. A stock option pool will also help you determine whether you need to dilute shares to infuse more shares into the stock option pool.

• Stock Type and Amount

Now, you will have to pick between two options; offering stock grants or stock options. In addition, you would have to identify whether you are issuing common or preferred stocks.

In addition, owners also need to decide whether they are willing to give away more equity in return for a reduced salary or vice versa.

• Contracts

Since this step is very critical, do not skip it. Get in touch with your legal team to create contracts for every shareholder (including your employees), as this can save you from any frauds in future if the need arises.

Wrapping it Up

By now, we have established that equity-based compensation is an effective way to attract and retain the best talent. However, certain advantages and disadvantages come along with this model. Before you decide whether you want to offer equity compensation, you need to understand what your business demands at that stage of its lifecycle.

Weigh the pros and cons and evaluate what works best for your business. If you are finding it difficult to conclude, trica has got you covered.

Get in touch with us today to know more about equity management, stock options pool, vesting schedules, and more.