Tips for Startups: Equity as Compensation
Compensation is a major factor when job seekers weigh up job offers. Whenever there is a boom in startup activity, like there is now, t becomes challenging for startups to manage their burn rate effectively and still attract skilled talent. Offering equity as compensation is a way in which founders can get employees, and contractors to believe in their vision and join them.
Crew spoke to Emma Ferguson, Senior Start-Up lawyer at Luna Startup Studio, to know more about startup equity, and the best practices for issuing them.
What’s the need for issuing equity?
To understand equity as compensation, it’s worthwhile to see the equation from both the employer’s and employee’s points of view. A founder has already believed in their product or service. Now they want the best in the business to partner with them. But the compensation they can offer may not be competitive. They won’t be able to match the salaries of the established firms in their sector.
From an employee’s point of view, there is considerable risk in joining a startup. The startup, especially if it’s in the early-stage and not well-funded, may not have the resources to offer them their desired salary. In some cases, they will even be taking a salary cut when joining a startup. Issuing startup equity solves the problem for both the founder and its employees.
What is equity?
As Emma puts it, “Equity is ownership of the business.” It’s commonly reflected as shares. When a founder says they have 100 percent equity in their company, it means they own 100 percent of the company’s shares. When there is more than one founder, equity will be divided among them.
So, for example, if a company has 100 shares, and if a founder owns 50 of them, they are said to have 50 percent of the equity in the company. When the company is sold, they will get 50 percent from the sale of the business. You don’t have to be listed to issue equity. Unlisted private companies can also issue shares and options.
Who gets equity?
Founders may issue shares to both employees within the startup and external advisors who offer crucial guidance. When they issue equity to their employees, it’s compensation for the risk they undertake. Entrepreneurs also sell their equity to raise funding for the startup. Typically, the investors who get in early are likely to get a bigger piece of the pie as the risk is substantially high at that stage.
There’s no prescribed level of equity that founders are supposed to issue to their employees. But it has been found that 15 percent is the standard startup equity for employees. Advisors get significantly minor equity, usually around one or two percent. Companies shouldn’t give away too much equity in their early stages as investors will be looking at the ownership structure later on.
A founder may issue shares to an employee at an early stage or wait till there is momentum in sales and revenue. Equity is a great way to get employees or contractors to have skin in the game. They are incentivised to work harder as the company’s success increases the value of their shares and their equity.
It’s important to note that equity is not a substitute for salary. That would be against the law. Equity is only a top-up. However, since advisors are contractors and not employees, they can be paid in equity.
In some cases, employees are given options, which are a promise of shares in the future. Options will convert into shares at some point in the future, after a particular period of time, called the vesting period. Options are usually tied to certain targets or key performance indicators (KPIs) that the employees are given.
This incentivises people to stay with the company and consistently add value. It’s important for founders and owners to clearly articulate to the employees what their targets are, and what’s expected of them. Employees should know precisely what they have to do to get full rights to their equity.
Tax implications & ESOPs
When equity is issued at a later stage, there will be tax implications for the employees. As the company builds in value, the issue of shares creates an upfront tax burden on the employees. An employee share option plan or ESOP is the solution to this problem. Under ESOPS, employers can plan out their share issue and create an appropriate vesting schedule that works well for the employees. Companies should also ensure that they research and utilise all the available tax incentives to lessen the burden.