The basic idea of startup equity is rather simple: In their early years, young companies often don’t have the capital to pay employees a competitive salary that’s made up entirely of cash, so the companies compensate them in part with stock in the company, or equity. The arrangement incentivizes employees and can be in the best interest of the business because if the value of the company grows, so does the value of their equity.
But in practice, issuing startup equity can be complicated. Below is an overview of some of the issues business owners should be aware of before issuing startup equity.
Vesting is the technique that allows employees to earn their equity over time. At startups, equity typically vests over four years, meaning employees must stick around for four years in order to own all their equity. If employees leave the company before the four-year period is up, they only receive a percentage of their stock based on the terms of the vesting schedule.
The four most common types of equity issued by startup companies are below.
1. Founder Stock
This is the stock that founders issue to themselves when the company is created.
2. Restricted Stock
This stock is commonly issued to employees or top executives when the company is founded, or shortly thereafter, and the stock value is very low. Holders of restricted stock own the shares from the day of their issuance and typically receive preferable tax treatment from the sale of the stock if it is held for at least one year.
Stock options, the most common form of equity compensation, give employees the right to purchase common stock in the company at some point in the future at a set price, also known as the “strike price.” A low strike price can be worth a lot of money in a company where the value is climbing quickly.
4. Restricted Stock Units
These are a relatively new form of equity compensation that is subject to vesting provisions and generally becomes actual, trade-able stock only after a large infusion of outside capital, such as from an initial public offering (IPO) or from the sale of the company.
Issuing startup equity can be an effective strategy when managed carefully. Becoming familiar with the process can help a business owner make a sound decision about whether it’s right for a business.