Avoiding Key Legal Mistakes in Startup Companies: Part 7
Part seven of our blog series on common legal mistakes made by startup companies focuses on the importance of appropriately structuring equity compensation plans. One of the most significant differences between established companies and startups is that startups commonly have much less cash available to compensate executives and employees. Typically, startups elect to rely on equity-based compensation in order to make up for the shortage of available cash. This forces the startup to prioritize short and mid-term benchmarks where investors demand substantial growth and returns.
While there is generally no problem with issuing equity-based compensation to founders or key employees, it is crucial that your startup appropriately structures its equity compensation plans so that such plans further the company’s operations. Failure to do so can create a real hindrance as the company looks for additional investment and could potentially lead to regulatory action against the startup.
7) Appropriately Structure Equity Compensation Plans
It is important to understand the legal, tax, and accounting implications of each type of equity award (such as, options, restricted stock, or stock appreciation rights) should a startup decide to use equity to compensate its employees. Before we address the implications of equity awards, the following basic points should be considered:
Startups are diverse. Just as numerous industries and companies operating in those industries exist, equity compensation plans are similarly as numerous. There is no one-size fits all approach. For example, employee equity awards in a New York startup may contain significantly different terms and significantly different amounts than employee equity awards offered by a California startup.
Market terms change with time. Even if you understand the basics of equity compensation arrangements, current market rates for startup equity compensation will vary by region and business sector. Compensation consulting firms can provide information on current market rates if your startup is considering awarding equity.
Consider the covered employees and the startup’s long-term growth. How deep will the equity pool go? If the startup issues a large amount of equity, will that hinder the startup’s ability to raise money from future investors?
Typical Equity Compensation Arrangements for Startups
The following list identifies various equity compensation arrangements that startups frequently offer:
Employee stock options.
Founders restricted stock purchase agreements.
Early exercisable stock options.
Phantom equity agreements.
Profits Interest.
Commission plans.
Retention agreements.
Management carve out agreements.
No matter the type of equity compensation arrangement your startup elects to implement, there are two key determinations that your startup must make. (1) What vesting requirements will be placed on the equity awards, and how any vesting requirements may impact the startup’s financial position, and (2) the size of the equity pool and how any distributed equity will impact the startup’s efforts to raise funding from subsequent investors. Beyond these considerations, any equity award must comply with applicable federal and state securities laws.
For more on ensuring compliance with securities laws, check out our blog here.
Summing it Up
Startups have the option to make up for their relative inability to pay competitive salaries by offering equity awards that could potentially lead to high returns, and the incentive provided by such awards is substantial. However, there are numerous legal consequences that a startup must address when considering any equity compensation arrangement. It is important to retain an attorney to ensure that your startup’s equity compensation complies with applicable law and simultaneously furthers the company’s goals.
Contact us today with any questions you have regarding capital raises for your startup and compliance with SEC regulations.
Check out the whole series: Part 1, Part 2, Part 3, Part 4, Part 5, Part 6, Part 7, and Part 8.
Photo by Van Tay Media on Unsplash
*The material and information in this blog is for general informational purposes only. In no way is this information to be construed as legal advice for a particular situation.*