Being owners gave us courage and a long-term mindset that suddenly brought things within reach. We realized that while company founders are owners, more importantly, so is the team. Igniting a true sense of ownership — the type that rallies the whole team around a single mission — starts with one’s equity stake in the company. Every person that joins your company sets the foundation for the future, especially in a growth environment where change is the one constant. Clearly articulating your values through your job offer helps you find alignment with those who already possess the ownership mindset that you seek. And to truly empower your team, it’s important that you give them the information they need to understand the upside of what they’re building.
Why offer equity to your employees? There are four main reasons you may want to give your team equity:
- To help you hire top talent: Talented candidates are taking a big risk when they come work for you. An equity stake gives them a shot at getting a big reward.
- To hang onto your best performers: Want your team to stick around? Incentivize each employee to grow with the company by granting equity that vests over time.
- To develop an ownership mentality: When employees are actual owners, they’ll be more committed to the long-term health of the company.
- To keep money in the bank: You might not have the cash flow to meet market-rate salaries of top talent just yet. Equity can keep you competitive.
While granting equity isn’t quite rocket science, it does require a careful balance of these competing drivers to ensure your team feels valued, motivated, and inspired to do incredible work. We’ll call out a lot of common practices, but we encourage you to view them with a critical eye. No two companies are the same, and their equity packages probably shouldn’t be the same either.
Why don’t we just ditch the cliff and vesting schedules all together? More stock for all! Great question. But hold up, space cowboy. Cliffs and vesting schedules are standard for a few reasons:
- They are in line with a person’s growing contributions to a company over time. When a stock option grant is given at the start of employment, that young buckeye hasn’t done the work to earn it yet. Vesting ensures that the maturing maverick gets equity commensurate with their time at the company.
- They ensure the employee is a good fit for the company. If you or the employee decides the company isn’t the best place for the employee, you haven’t given away loads of equity.
- They incentivize people to make a long-term investment in your business by rewarding them with equity over time.
One more thing to note: if you have accelerated vesting schedules or no cliffs, investors will often ask you to adjust both to a more standard structure when you receive financing. Founders should also consider having vesting schedules; this is something that investors expect, too. It signals to all partners (employees, investors, and more) that the founders are in it for the long haul.
Sounds pretty adventurous, right? The standard approach is a four-year linear vesting schedule with a one-year cliff. But before you go with a vanilla vesting schedule, make sure it jives with the values and time horizons of your business. For example, some companies looking further down the road offer five-, six-, or even ten-year vests.
For early-stage startups, granting stock options is usually the way to go. If you’re considering issuing stock straight up, it’s good to be aware of the tax implications for your employees. Granting stock options lets your team choose when to exercise. This choice gives them the privilege of waiting until they think their investment in the company will be worthwhile. However if employees are granted stock directly, this choice evaporates. They’ll own the stock as soon as it vests, possibly triggering, gulp, thousands of dollars in taxes. If the stock can’t be sold because the company isn’t public yet, paying those taxes can be a tall order. In a nutshell? If you’re gung-ho about granting alternative forms of equity, make sure that your employees are too.
Set an expiration timeline
When an employee leaves, when should their stock options expire? The standard expiration is three months after someone terminates their contract, but that trend is slowly changing. Many think it isn’t fair to force employees — especially those who don’t have large savings — to exercise their options before they’re ready for a potential financial burden. A longer expiration timeline can allow your team to exercise when they have a more substantial income or when stock becomes liquid after the company goes public.
While providing more flexibility is great for employees, there are significant administrative strains if you offer an extended expiration timeline. They’re a bit convoluted, but here’s a quick explanation: The US tax code provides two types of stock options: ISOs (incentive stock options) and NSOs (nonqualified stock options). In short, ISOs can only be issued to employees. They have special tax benefits because they’re meant to be used as carrots for employees. NSOs are for anyone, including employees, contractors, and investors.
Why do these matter? ISOs expire three months after an employee leaves a company. That’s why the standard expiration for options is also three months. So, if you’d like to let your team exercise more than three months after leaving, you can convert their ISOs to NSOs and set a new expiration timeline. While this favors your employees, managing the switch means more work for your legal and accounting teams. You’ll also increase the number of option holders who are not employees, which isn’t ideal. It’s up to you to weigh the pros and cons and figure out if offering a more flexible exercising timeline is core to your company’s values.