Employee Equity 101: An Entrepreneur’s Guide
Updated: Sep 28, 2020
Employee Equity Essentials
When you’re considering issuing equity to your team, it can at first feel like there is a steep learning curve. Fortunately, with an understanding of a few basics, it is possible to make educated decisions that support both the needs of your workers and the health of your company at the same time.
It’s important to remember the ultimate goal of equity: Giving workers skin in the game to help the company succeed long term, as well as helping them feel that “we’re all in this together.” The ability to successfully generate this alignment can vary vastly depending on which equity system you choose to implement.
What are the most important things you need to understand when setting up an equity system for your company?
For starters, it’s important to make decisions about three main factors:
1. Units: Which type of equity will you be distributing?
2. Distribution: How will shares be split between workers?
3. Transparency: How much information would you like workers to be able to see?
Understanding Equity Units
All equity is not built the same. The type of units — sometimes commonly referred to as “shares” or “stock” — can actually make a massive difference across many dimensions of your business, from taxation to who gets to make decisions about the future of the company.
Common types of equity issued to workers include: stock, stock options, and dynamic equity.
The oldest kind of equity incentive is stock. Stock represents a direct share in the ownership of a company. However, over recent decades, stock has fallen out of favor relative to stock options and dynamic equity because issuing stock comes with some major problems.
The biggest challenge with stock is that team members have to buy it. Workers are first taxed on their take home income, and then have to use what is left after tax to purchase shares in the company. So, what if the company fails a year later or loses value? People often aren’t even sure if the company is worth much. Will the stock value increase or decrease over time? Granting stock gives your team members shareholders’ rights and the opportunity to vote even after they leave. Outright stock also puts your company at risk. Many investors will avoid companies with a bunch of voting shareholders who are not actively providing value to the company due to the liability they create.
Stock options were originally introduced to fix some of the problems with stock. In practice, stock options usually end up creating liabilities and unseen expenses for workers, along with a commensurate drop in trust for leadership. Stock options attempt to defer the date of when the worker would have to buy the stock. The goal is to move it to a time in the future that is more convenient for the worker. This usually occurs later on when the worker is leaving the company, or when the worker has a better idea that the company is likely to be successful. Here’s when problems appear with stock options.
If the worker departs before the sale of the company, they will likely lose all of their stock options due to tax rules. The tax rules in the United States (and many other countries) stipulate that unless you buy the stock within 90 days of departure, you will have to forfeit them. Most workers will not have the funds to buy the stock and will likely let the equity vaporize. Workers are often unlikely to feel safe investing if it’s not very clear that the company will be successful (and the stock value will go up) in the near future.
If a worker is granted stock options and the options lose value, they are effectively worthless. Imagine how a worker feels after they put in their best effort, expecting to receive a fair slice of the company, only to be told later that they have to buy the options. Now imagine how they would feel if they scrape together a bunch of cash, invest, and then watch the company go bankrupt a few months later? This is a leading reason why workers feel demotivated when they think of traditional stock option systems.
Perhaps the most problematic issue with stock options is that they are very complex. Most workers will throw up their hands and say, “I don’t get it,” even after spending hours with expert advisers who explain the taxation and how the plan works. Why? The complexity has to do with two things. First, there is a lot of legacy baggage in the stock option system. Second, those working in the legal system (lawyers) are not incentivized to make it easier. The more complex the system is, the more they can legitimately charge for their services. A complex system requires complex thought and navigation.
Most workers who receive stock options say that they don’t really know what they are, they don’t really know how they work and they don’t really understand when and even if they’d receive anything. They don’t want to feel like a fool who works extremely hard, thinking that they will receive a fair share of equity, later to find out that they won’t actually receive their hard earned equity because of some legal complexity.
People in different countries call this form of equity by different names. In the US, Upstock's proprietary employee stock plans uses dynamic equity, a world class equity system based on Restricted Stock Unit (RSUs). In Europe, many countries have a related equity plan called synthetic equity. Others call them virtual equity. This is the form of equity currently used by Google, Facebook, Microsoft, Amazon, Uber and most successful companies. The key point that makes dynamic equity stand out from other equity instruments is that workers do not have to pay tax when the the stock is awarded. Dynamic equity is an equity award, to issue equity at a certain point in the future when certain conditions are met. Usually those conditions are that the worker has earned them over a period of time and that the company was successful. Meaning that he company was either acquired or had an Initial Public Offering (IPO), also known as a landmark event. Only when there is cash to pay the tax, is the dynamic equity converted into stock. The stock is of course then taxable as income at the market value upon conversion.
Essentially, the worker receives their stock if and when there is money available to pay any taxes that would be owed, if and when the company is successful. This substantially helps to fix the problem of having to pay tax on stock or buy shares before a worker knows if the company is likely to be successful. Additionally and very importantly, workers get to keep some or all of their equity after they leave a company. This design protects the interests of the earliest employees; those who took the greatest risk in the earliest days of the company.
Perhaps the largest advantage of using dynamic equity is that they can actually produce real alignment and motivation with your team. Using an equity dashboard with these top-notch equity system is far better than the chaos that can ensue from issuing stock options.
Here in Silicon Valley, time and time again, we hear stories about how stock options demotivate workers because they are too complex and are often conveniently used to take equity back from workers. Stock options can make workers feel like management is pulling a fast one; trying to take advantage of them.
Dynamic equity offers a different option. Everyone, including workers and managers, want to make the company extremely successful so that when their equity is converted into stock it is worth as much as possible. This occurs when the equity system is one that everyone can understand. Dynamic Equity is much easier than stock options to understand. When you combine dynamic equity with a real-time equity dashboard, like the one that Upstock offers, workers gain a lot of confidence in the equity system and their leaders. Seeing and understanding is believing!
How is the equity going to be distributed? Vesting or fair, real-time formula?
At one end of the spectrum is the old model called vesting. It’s when a worker trades time for equity units. Here’s a simple example: “The company will give you 10,000 shares for equity for each year you work.” The amount each team member gets is usually based on units of time and decided on before the work begins. The amount is based on the value of what the company hopes the worker will produce. So long as the worker shows up and puts in average effort, the worker will earn the rights to the equity, regardless of the quality of the work or how much value the worker actually contributed.
Performance Equity (PE).
At the other end of the equity spectrum is performance equity (PE). Performance equity utilizes a simple formula to determine what a fair amount of equity to be earned is. PE bases this on the amount of time worked and the value of that work. The value is usually determined by a worker’s pay rate and the ongoing agreed upon value of the output. The goal of PE is to fairly reward team members for working harder and for producing better results. It helps reward workers, in real-time, with more equity for better output. The proportion of each team member’s equity is not set ahead of time. Instead, it fluctuates depending on each workers quality of contribution. Each worker can view their share of equity in real-time using Upstock’s dashboard. Again, seeing is believing. Imagine an equity structure where people are not only incentivized to show up for work, they are actually invested in working hard and giving you their best every day. Often, this is a deciding factor if a company is successful or forgotten.
Traditional Stock Options vs. Dynamic Equity - which is better?
Time has shown that stock options only provide huge benefits to companies that are able to achieve a drastic increase in their stock price. Ultimately, stock options only work as a motivational tool for workers when their stock price increases. When a company’s stock price stays flat or even decreases it can have a discouraging effect on worker motivation.
Simply put, stock options have become more like a lottery ticket than a fair and beneficial means of compensation. They’re difficult for people to understand, and feel like a gamble.
It’s for this reason that over time people have been looking for alternatives to stock options and have been using different approaches to sharing company equity, such as RSUs. Sticking with stock options as the central means to compensate and reward workers no longer works.
Every company has it's own unique circumstances, as such it's important to understand the benefits and weaknesses of different equity units to create the best plan for building and scaling your company. This may even include utilizing an equity plan that combines stock options and dynamic equity. Solely relying on stock options is no longer the best solution. It’s time to move onto something new, to create equity plans that align and protect the interests and futures of founders, workers, investors, and the company.