Employee Equity 101: An Entrepreneur’s Guide

Casey Fenton

September 6, 2020

Employee Equity 101: An Entrepreneur’s Guide

Employee Equity 101: An Entrepreneur’s Guide

Employee Equity Essentials

When considering issuing equity to your team, it can initially feel like a steep learning curve. Fortunately, with an understanding of a few basics, it’s possible to make educated decisions that support both the needs of your workers and the health of your company.

What is the goal of employee equity?

Equity compensation aims to incentivize and retain key employees and attract or recruit talented candidates.

 

Offering employees equity is a great way to reward top performers as it further encourages them to develop an “owner's mindset.” It is also a great recruitment tool for top talent, as equity compensation can potentially be worth more than a cash salary.

If employees and potential candidates believe that a company has a decent chance of becoming successful, an equity plan becomes a more attractive option to them in terms of benefits and compensation.

It’s important to remember the ultimate goal of equity: Giving workers skin in the game to help the company succeed long-term. It’s also a way to make them feel that “we’re all in this together.” The ability to successfully generate this alignment can vary 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, make decisions while keeping these factors in mind:

1. Units: Which type of equity will you distribute?

2. Distribution: How will the shares be split between workers?

3. Transparency: How much information would you like your workers to see?

Understanding Equity Units

All equity is not built the same. The type of units — sometimes called “shares” or “stock” —  can make a massive difference across many dimensions of your business, from taxation to who gets to make decisions about the company's future.

Common types of equity issued to workers include stock, stock options, and dynamic equity.

Stock

What does stock mean?

“Stock” (or “shares of stock” or “shares”) refers to a unit of ownership interest in the company, particularly in corporations.

 In other words, stock represents a direct share in the ownership of a company. As a form of equity incentive, however, directly issuing stock has fallen out of favor relative to stock options and dynamic equity because issuing them directly comes with some major problems.

The biggest challenge with stock is the team members’ need 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. 

Many investors avoid companies with a bunch of voting shareholders who are not actively providing value to the company due to the liability they create.

What are the usual types of stock? 

Common Stock

Common stock is a general term used to refer to a common class of shares that generally entitles investors to a share in the company's profits (which are usually paid through dividends) and voting rights on key decisions in the company. 

Preferred Stock 

Preferred stock is another general term that refers to a class of shares that enjoys certain “preferences” over common stock or shares. 

For instance, preferred stock investors could be preferred over holders of common stock in any distribution of profits. In the event of a liquidation, preferred stockholders could also have preference and priority in being paid out. 

Preferred stock may also be cumulative or non-cumulative. Cumulative preferred stock entitles the holder to missed dividends if they are not paid in a given year, while non-cumulative preferred shares don’t.

Preferred stock can have restrictions, such as not having any voting rights (which is important when making corporate policies or electing a board of directors). 

Stock Options

Stock options were originally introduced to fix some of the problems with stock. In practice, stock options usually create 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 when the worker leaves the company or when the worker has a better idea that the company is likely to be successful. 

Stock options give you the right to purchase shares of stock at a set price within a certain timeframe. They are often used as a form of compensation for executives and key employees, as they can provide a significant financial incentive to help grow a company. While stock and stock options represent ownership in a company, they are two very different things, and it's important to understand the difference before investing.

When people talk about investing in the stock market, they usually refer to buying stock. Stock is a type of security that represents ownership in a corporation. When you buy stock, you become a shareholder and are entitled to a portion of the corporation's profits (if there are any). Stock options are a bit different. 

A stock option is a contract that gives you the right, but not the obligation, to buy or sell stock at a set price on or before a certain date. Stock options are often used as a way to hedge against stock market fluctuations or to speculate on future stock prices. Because stock options give the holder more flexibility than stock, they are often seen as a more risky investment.

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 succeed (and the stock value will go up) soon.  

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. 

Imagine how they would feel if they scraped together a bunch of cash, invested, and then watched 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, the stock option system has a lot of legacy baggage. 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, don’t really know how they work, and 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, but later find out that they won’t actually receive their hard-earned equity because of some legal complexity.

Dynamic Equity

People in different countries call this form of equity by different names. In the US, Upstock's proprietary employee stock plans use dynamic equity, a world-class equity system based on Restricted Stock Units (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 distinguishes dynamic equity from other equity instruments is that workers do not have to pay tax when 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 the 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 company's earliest days).

Perhaps the largest advantage of using dynamic equity is that it can actually produce real alignment and motivation with your team. Using an equity dashboard with this 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 and trying to take advantage of them.

Dynamic equity offers a different option. Everyone, including workers and managers, wants to make the company extremely successful so that it is worth as much as possible when its equity is converted into stock. 

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 of 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 the average effort, the worker will earn the rights to their 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 worker's 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. This is often 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 can drastically increase 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.

For this reason, 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 its 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 include utilizing an equity plan combining 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.

 

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