Advisors often play a central role in the success of a high-growth startup. Whether providing technical and operational guidance or making introductions to potential employees, customers, partners, and investors, the right advisor can help accelerate the success of a startup. For several reasons, it is typical for early-stage companies to compensate advisors using equity rather than cash. This blog post assumes that the start-up company has been organized as a corporation, which is the most common structure and easiest to use if you are considering using equity to compensate employees, advisors, and other service providers.
Using equity compensation raises many questions, however, including:
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How is equity issued?
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How much equity is typical?
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When should it be issued?
How is Equity Issued?
Of Stock and Stock Options
The two most common ways to issue equity as compensation are to issue stock outright in exchange for services (often referred to as “restricted stock”) and issue stock options, giving the advisor the ability to purchase stock in the future at today’s price. Both restricted stock and options can be subject to vesting, meaning that the full value of the compensation is realized over time as the advisor provides the services.
The two types of compensation are treated differently for tax purposes, however. As a general rule, the advisor will be taxed on the value of the restricted stock upfront, while the option’s value will not be taxed until some later event, such as a sale of the company. However, this delay in tax comes at the expense of only realizing the upside in the stock above its current value. As a practical matter, for very early-stage start-ups, the valuation is so small that the tax differences are minimal.
As a result of these differences, the same amount of equity is more valuable when issued as restricted stock than a stock option, so the company will typically prefer to use stock options. Stock options also tend to be more common, particularly beyond the pure start-up stage as the valuation of the company increases.
Have a Written Equity Incentive Plan
Regardless of whether the equity compensation is issued as restricted stock or as stock options, it is highly advisable to establish a formal equity incentive plan for at least three reasons:
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Standardization of terms across all participants. The last thing a startup needs to spend its legal budget on is negotiating one-off, customized agreements with each person that might receive equity compensation. Having a plan significantly eliminates the variables and turns equity compensation into something that can be standardized and process-driven.
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Expectation setting. A plan sets aside a set amount of equity that you expect to issue in the future, typically 12-24 months. Although you can usually change the amount set aside as needs change, having a set plan size communicates to investors, employees, and other stakeholders your long-term plans regarding the level of employee and service provider ownership in the company.
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Securities laws compliance. All states and the federal government have laws restricting how and when you can issue equity. Having a plan will make compliance with these laws significantly more manageable now and easier to verify for future investors.
You will spend a little more money upfront to establish a plan, but if you issue equity more than once during the company’s history, you will be much better off having a plan.
The Mechanical Details
Establishing an equity incentive plan will require board and stockholder approval and state filings. After the plan is approved, issuing equity will require board approval. The process is simple, but keep in mind that you will need to value the company’s shares every time stock options or restricted stock are granted. The most common way to do that is by hiring an external firm to conduct a 409A valuation. You will want to check with your legal and accounting advisors to ensure that your valuation will be supportable.
How Much Equity is Typical?
Generally, the earlier the stage of the company, the more equity will be offered. For one, earlier advisors assume a greater risk of failure — they might not ever be compensated for their services should the company fail. Additionally, all equity holders are diluted as the company grows and additional shares are issued so that earlier equity holders will experience more dilution.
Another factor to consider in determining how much equity to offer is what services will be provided and how much time will be spent. An engaged advisor who plays a critical role in your company’s future and growth may be issued 0.5% to 1.0%, depending on the stage of development the company is in. An advisor with a more limited role may be half of that. The equity will typically vest over 1-3 years, which should be matched to the time frame that you will need the advisor’s services.
When Should It Be Issued?
Whether you decide to issue restricted stock or stock options, you should typically give the option as soon as the work begins (although not before), rather than in installments over time or after the work is completed. The vesting schedule protects the company if the relationship is terminated early, and granting the restricted stock or stock option early takes advantage of the lowest valuation, which is suitable for everyone.
Inceptiv Law
Seek out and establish a relationship with legal counsel early in your company’s journey. At Inceptiv Law, we are experienced in providing legal advice and business resources to high-growth companies. Contact us through our website to schedule a consultation. We can also be reached at 858-208-0193.
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