The Benefits and Risks of Issuing Equity In a Startup

by Christine Mortensen on August 14, 2014

This month we answer the question: What are the benefits and risks of issuing equity in my startup and what should I look out for?

Startups often compensate employees and/or service providers with equity in exchange for services.  The type and form of equity may vary based on your company’s desired outcome and goals, which come in various forms such as stock options, stock grants, stock appreciation rights and restricted stock to name a few.

Advantages

When you pay employees with equity, it affords your employees with an opportunity align their interests with those of your company.  These incentives are instituted for a number of reasons, but some of the benefits are as follows:

  • Attract and retain employees;
  • Reward employees for their contribution to the company’s growth and success;
  • Encourage performance in employees; and
  • Reward long-time value creation and thinking by employees.

Disadvantages

Despite the benefits of offering equity to employees, companies should proceed with caution.  As with most business decisions, there are risks that should also be weighed before making a decision to issue equity to an employee.  Employee ownership can:

  • Create management problems;
  • Produce unintended tax considerations; and
  • Create liquidity consequences for both the company and its employees.

Tips to Follow

In the event you are contemplating issuing equity-based compensation, please keep the following tips in mind:

Service Description

In the event you are exchanging equity for services, it is important that your service agreement includes as much detail as possible since this will form the basis of the service providers interaction with your company.  Create appropriate objective criteria or benchmarks that can be easily measured to ensure compliance.

Vesting Schedule

In order to protect your company and its founders while incentivizing employees or service providers, equity-based compensation is often earned subject to a vesting schedule.  You should establish reasonable vesting schedules depending on the company’s goals.  Often this is set up as a percentage of equity vesting over a period or conditioned on continued employment with any unvested interest forfeited when the employee or service provider leaves the company.  There may be additional “triggers” that accelerate the vesting upon reaching clearly defined milestones or certain events such as a change of control of the company.

Termination

Proper care must be exercised when terminating a service provider and in particular at-will employees.  Language must be drafted to ensure that termination may happen at any time prior to any vesting date and in the event of termination such employee will lose all rights to any unvested equity compensation.

Comply with State and Federal Securities Laws

There are restrictions when a company may offer or sell its securities, so it is extremely important that you ensure your business either qualifies or is exempt from certain federal and state registrations.  In the event you fail to comply, there are adverse consequences including fines, injunctions, penalties and possible criminal prosecution.

Documents

Depending on the type of equity-based compensation chosen, there are typically multiple documents involved when drafting these deals.  An employment agreement or service agreement is typically used to describe the services to be provided in exchange for equity.  There is often an agreement to be executed by the company and each employee/service provider that specifies the individual equity-based compensation granted, including the vesting schedule.  Additionally, there will be an agreement which contains the terms and conditions of the equity-based compensation granted including the restrictions regarding the financial rights and duties.  Each company must also issue the proper approvals, resolutions and notices.

A well-designed equity compensation plan can be beneficial to both the company and its employees; however, proper care must be taken to avoid putting your company at risk.

 

About the Author

Tricia MeyerTricia Meyer is managing attorney of Meyer Law, a forward-thinking boutique law firm providing top-notch legal services to clients ranging from startups to mid-sized companies to large corporations in a variety of industries including technology, telecom, financial services, real estate, advertising, marketing, social media and healthcare. Learn more at MeyerLawGroup.com and follow us on Twitter @Tricia_Meyeror @Meyer_Law.

 

 

DISCLAIMER The content in this article is for informational purposes only and does not constitute legal advice.  Readers should contact a qualified attorney to obtain advice with respect to any particular issue or problem.

 

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