If you are in the startup community, there is a good chance you have heard of an equity incentive plan but may not know exactly what it entails. SPZ Legal can help you on this journey. This article provides an overview of what an EIP is, including some of its most important components, what common types of awards are granted in these plans, vesting provisions associated with awards, securities law compliance and exemptions, and other legal implications of these plans.
What is an Equity Incentive Plan?
An Equity Incentive Plan (EIP) is a structured approach to grant either company shares (actual ownership stake in the company) or the option to buy shares to employees, advisors, directors, consultants, or other eligible service provider participants. There are three different types of grants that are often utilized.
Stock options grant the right, but not the obligation, to buy company shares at a set exercise price within a specified time frame. This is the most common type of equity incentive compensation for all types of service providers in startup companies. There are two different types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). An ISO is exclusive to W-2 employees and comes with tax advantages. An NSO can be granted to non-employees (i.e., advisors, contractors, directors) but is less tax efficient than ISOs.
Restricted stock awards (RSAs) are company shares issued to participants, but with certain restrictions. Holders of these shares may have shareholder rights such as voting rights and economic rights. Ownership is immediate, but there are vesting requirements before they can be fully ‘owned’ by the recipient and other restrictions on transfer; this is why they are ‘restricted.’
Restricted stock units (RSUs) are promises to grant stock or its cash equivalent once certain conditions (like vesting) are met. Unlike restricted stock awards, RSUs aren’t actual shares until they vest, therefore, holders may not have certain shareholder rights like voting or dividends. RSUs are typically reserved for service providers of late-stage and public companies.
Why should my company have an Equity Incentive Plan?
First, EIPs ensure that startups comply with securities regulations, specifically the Securities Act of 1933, which mandates the filing of a registration statement with the Securities and Exchange Commission (SEC) or having an exemption from registration before offering or selling securities (including equity in a company) to anyone (investors and service providers alike). By adopting an EIP, startups generally fall within an exemption from registration.
Second, the EIP provides a clear method for determining equity grants by establishing a fixed number of shares in a share reserve aka an “option pool”. This consistent denominator allows startups to anticipate the impact of new equity issuances on existing stakeholders, ensuring that dilution is calculated and transparent for all involved. For example, if the company has an EIP share reserve of 1,000,000 and 10,000,000 fully diluted shares total, its EIP share reserve is 10% on a fully diluted basis. If the company wants to provide 0.1% to an early-stage employee, it can grant 10,000 shares to that person under the EIP without changing the fully diluted percentages of the entire capitalization table. Initially, most startups reserve between 5% and 20% for the EIP share reserve, which is dependent upon the company’s hiring plans and equity compensation philosophy. Additionally, most institutional investors will require that the share reserve is within this range on a post-money basis upon the closing of a venture capital financing.
What is the typical vesting schedule for equity grants?
A vesting schedule incentivizes service providers to continue providing services to earn their equity. There are three common types of vesting schedules. This first vesting type is time-based. Under this schedule, your employee will earn shares over a defined period. The most common schedule for startups is a four year vesting schedule with a one-year cliff, meaning that 25% of the shares are vested upon the 1-year anniversary of the vesting commencement date, and the remaining shares vest thereafter monthly over the next three years until the full amount is vested. Leaving before the cliff (or each subsequent vesting date) means that the unvested shares return to the company’s EIP share reserve. The second vesting type is milestone-based. This is when shares are earned upon achieving certain goals, like finishing a project or hitting specific valuations. Finally, and less common, is a hybrid vesting schedule. This is a mix of time-based and milestone requirements.
The following is a typical example of a time-based vesting schedule with a one-year cliff:
Example: TechCorp hires Alex Engineer on January 1, 2020, with an option grant of 24,000 shares. The vesting is time-based over four years with a one-year cliff. On January 1, 2021, 6,000 shares (1/4 of 24,000) are vested. After that, 375 shares vest monthly. By January 1, 2024, all 24,000 shares are vested. If Alex Engineer leaves on December 31, 2023, Alex Engineer will forfeit 6,000 unvested shares, which will go back to TechCorp’s EIP share reserve.
How do I set up an Equity Incentive Plan and determine the price for the equity?
Before your startup can make equity grants to service providers (after the founding team), the company must adopt the Equity Incentive Plan and related documents through working with an attorney team to prepare the documentation and ensure the EIP is properly approved by the board and stockholders of the Company.
After adopting the EIP, it is best practice for your startup to go through a 409A valuation process, which is an assessment used to determine the fair market value (FMV) of a private company’s common stock, ensuring compliance with the Internal Revenue Code’s Section 409A.
Getting a 409A valuation minimizes tax implications for shareholders, strengthens equity terms, and ultimately lends you more credibility when engaging with investors. To streamline the valuation process, it is recommended that businesses find a reliable and easy to use cap table management platform.
Your startup should obtain a 409A valuation before offering any equity to employees, but should also considering doing so:
After raising a round of capital
Once every 12 months (or after a material event), or
If it’s approaching an IPO, merger, or acquisition.
Once the 409A valuation is obtained, the company’s board of directors must formally approve the 409A valuation and the promised equity grants, which is typically done by one-off board consents or regularly at the Board’s quarterly board meetings.
Setting up an EIP is a comprehensive process that requires strategic decision making and compliance with securities and tax requirements. By equipping yourself with this knowledge, you not only ensuring your startup’s compliance but also reinforcing its foundation for sustainable growth. Consider consulting with SPZ Legal and its team of EIP experts to tailor an equity incentive strategy that best serves your company’s unique needs!
This blog post was written by Sanam Analouei, Ryan Shaening Pokrasso, and Becky Mancero.