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Sharing Equity in a Startup or Established Entrepreneurial Venture

It's easy to get lots of technical information about stock options, restricted stock, stock appreciation rights, phantom stock, performance shares, and other equity sharing tools. It's also easy to find guidelines for executive ownership of equity in public companies. It's a different matter, however, to learn how to tailor an equity-sharing program in a closely held startup or established entrepreneurial company. The equity consulting industry, frankly, would much prefer to focus on large public companies, and some of the best-known names in the field won't even accept engagements from companies below a certain size. In this article, we outline the key issues that leaders in all companies should consider in setting up or modifying a program.

Decide How Much to Share: The typical approach is to say "we'll give out x% of the stock." Often, that's 10%. This is a very crude way to start, however. Ten percent of a company with an established product and a history of profits is a very different matter than 10% of a company with no product, no profits, and a lot of debt. But owners often think "there is some percentage of ownership we are willing to give away, so let's settle on that."

This creates a number of potential problems. What if you give away most of the 10%, but then need more to give to new hires when you grow? What if 10% of the equity turns out to be not worth much and thus is not much of an incentive? What if it is worth more than you really need to give out to attract and retain talented people?

Instead, we suggest a different approach. Give out ownership based on meeting corporate targets, with more given out if a stretch goal is met, and none given out if the base goal is not met. This can be done on a regular basis, with amounts set so that they are sufficient to get people's interest, but not so high as to make majority owners feel like they are giving too much away.

Decide Who Gets Ownership: Most people start off with the assumption that they just want to reward "key performers." We agree with the premise but disagree with the usual definition of "key." No matter how good your product or service is, if the receptionist is rude, the customer service agent uninformed, the warehouse clerk too slow, or the programmer distracted, then not much good is going to happen. Everyone in your company has the potential to make a contribution, often well beyond what their narrow job descriptions entail. Research cited elsewhere on this site shows definitively that sharing ownership broadly is a more effective business strategy than focusing it narrowly.

Decide How Much Each Person Gets: There are a number of common approaches here. Many new companies look to comparison data to ask how much people at various levels get in terms of a percentage of total equity. That does not seem very productive to us, for the same reasons setting a percentage to give away overall doesn't make much sense. Instead, the key should be to provide a reward that is financially meaningful to employees-one big enough to attract, retain, and motivate them, but not so large as to waste corporate assets. Once a range of value has been set, then decide whether to base the award on merit, salary, or some other formula. Merit-based approaches are very popular, but just be sure that the process of determining merit is considered fair.

Think About Frequency: Many companies load up equity grants in the first year, reserving much less for later. But that creates a lottery effect for employees. If you join when the stock is at a favorable price you do much better than someone who comes in later at a less favorable one. Smaller, but more frequent, grants smooth out this effect and allow for ongoing incentives.

Accounting Issues: Your company will have to show a charge against earnings for the present value of awards. Some non-option awards will be adjusted year-to-year for changes in value. While this charge is an issue for public companies concerned with the "optics" of their earnings, it is less an issue for closely held companies who can explain what is behind the charge to users of their financial statements.

Deferred Compensation Issues: Under a tax law fully effective in 2007 (Internal Revenue Code Section 409A and the regulations thereunder), most kinds of equity awards are subject to deferred compensation taxation requirements. You can generally be exempted from these rules by issuing awards at fair market value, which is either set by an appraiser or through a series of calculations within IRS guidelines. If your award is not exempt, employees generally have to decide the date when they will exercise the award not less than 12 months in advance.

Pick a Kind of Equity: Stock options come in two flavors, nonqualified and incentive. The increase in value of nonqualified options is taxable as income on exercise to employees and deductible to the employer at that time; incentive options can qualify for capital gains treatment and not be taxed until sale if certain rules are met. But the employer gets no deduction and the employee may have to pay alternative minimum tax (AMT). Restricted stock gives or sells employees actual shares but requires some condition, such as years of service, to be met before they can actually take possession of them. Tax treatment varies and is described in more detail elsewhere on this site. Stock appreciation rights give employees a cash or stock award for the increase in the value of shares over a period of time; phantom stock gives employees the actual cash value of the stock, instead of the stock itself. Both are taxable in the same way as a cash bonus.

Getting Help: Choosing a professional advisor with extensive experience is essential. Make sure they can provide all the alternatives, instead of just trying to sell you on their favorite approach. The NCEO's staff can also provide consulting to review your alternatives (for contact information, see our page on consulting). The NCEO does not actually set up plans, so we can approach this in a more objective way than consultants who hope you will go on to hire them to set up plans. Generally, a one- or two-hour phone consultation is sufficient to help company leaders make some essential choices.

For a book-length guide to choosing and designing equity plans, see The Decision-Maker's Guide to Equity Compensation.

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