As we discussed in Phase 1, we’re going to kick off our process with some of the fundamental structural items of our stock plan. These should be fairly easy decisions to make, but that doesn’t mean they aren’t important! They are just less complex.
There are essentially 4 components to setting up the fundamental structure of our Stock Plan:
We’ve laid out the decisions in this course to be somewhat sequential from “easiest to agree upon” to “harder to agree upon”. We don’t necessarily need to agree to all of these items right now, but it does help to at least try to focus on some of these issues so that we can get some cycles as a team in coming to a consensus.
These are decisions that shouldn’t affect any one member individually. We’ve deliberately separated this from the discussions around individual equity stakes and the conditions of managing someone’s equity so that we can isolate those discussions when the time comes.
Said differently: if we can’t agree on the basic stuff... we’ve got bigger problems.
Before we get into the weeds on some structural decisions, let’s make sure we’re good on some key terms that will come up over and over. Key terms are super boring to read, so let's keep our attention on the absolute most important moving parts. These are the pieces that you absolutely need to know if you're going to do even a basic equity split.
If some of these don’t make sense now, don’t worry. We’ll provide a ton of context as we go forward. Now let’s get on to some meatier stuff.
Not all stock is created equal. When it comes to determining how our stock structure works, we have a handful of different ways in which we can hand out our stock.
For example, we can give members 100% ownership in our company (equity) or we can just give them the option to buy equity at some later date (stock option). We can even create something called “phantom equity” that provides a financial benefit like stock but isn’t actual equity in the company. And it’s spooky.
It’s worth at least having a basic understanding of the 3 most popular types of stock we can issue even if we just arrive at the default decision of “just give everyone regular equity”. There are some important nuances in how we might want to structure our stock so that we aren’t giving away ownership or controls that we don’t need to. Most people don’t realize this is even an option, so it’s worth knowing about.
By default, the Founders of a business have equity – we all own actual shares in the company. We’re directly responsible for the welfare of the company, including things like paying taxes and covering payroll. Our employees, however, don’t necessarily need to own equity or maintain the same liabilities that we do. This is where the stock structure comes into play.
We have 3 ways we can grant employees (or partners, advisors and investors) stock in our company:
We can give them the same types of shares that we have. That would subject them to the same benefits we get but also the same liabilities (like having to cover their share of costs or pay corporate taxes). When we go beyond splitting the equity amongst the co-founders, the next two options become really important to consider.
We can give staff the “option” to buy stock in the company at a later date. That means right now they don’t “own” anything, but in the event the company is sold or goes public, they can “exercise” the option to buy stock and earn the benefit at that time.
We can give people the benefit of equity (getting a cash payout) without actually having to give them equity ownership in the company. This works more like a company bonus structure, whereby if the company hits certain milestones (typically a sale) the team gets a percentage of the proceeds.
As with anything in life, there are some pros and cons to each. Mind you, most of our focus here won’t be on what type of stock the Founders get in the company – we’re focused on what everyone else gets. Chances are we’re all getting regular ol’ equity. Instead, we’ll weight the benefits and costs of how we distribute stock to everyone else.
The most basic form of offering equity is just to offer an ownership stake in our company. If we award a member a share, it’s theirs and that’s all there is to it. Sounds simple, right?
For the most part it is. If you and I split our equity 50/50 and we both own half of the company, that’s easy to understand. And millions of companies have been founded with exactly that structure in place, so while it doesn’t solve every problem, it definitely has a strong track record.
What is often lost in that translation is how equity is distributed. Simply slicing up the pie amongst a handful of co-founders is one thing, but once we start to hand equity out to a larger group of people, particularly employees, things start to get way more complicated.
When to use it
There are some meaningful drawbacks to just handing out equity and that’s really the heart of the discussion.
First off, we have to make sure that handing out equity is the best way to accomplish our goals. If our goals are to reward talent with compensation in the event we sell or want to distribute profits, we don’t need to give regular equity to do it. We can, but it’s not necessarily our best or only option.
Second, we need to understand the challenges around just handing out straight equity because that is really what may drive our decision to use Stock Options or Phantom Equity to accomplish our goals.
Most Founders have no idea why using regular equity would have any downside because, frankly, most people have never done this before (why would we have?). Let’s look at the main costs and challenges we may face by handing out regular equity:
When someone owns a legal share of a company, they often have specific rights ranging from voting options to complicated fiduciary rights. If our goal is to create cash incentives on upside, we don’t necessarily have to introduce complex control issues as well.
If we want to buy back a share of actual equity, there is likely a fair market cost to do so. The problem is that we probably won’t have a bunch of cash sitting around waiting to “buy someone out” and therefore we may be stuck.
Fun fact – if we get handed a share of equity, and that equity has marketable value, the IRS may tax us on the value, regardless of whether we have any actual cash to show for it. That could be a massive problem for anyone that just got granted equity. This is a complicated legal and tax matter that we’ll definitely want to discuss with our advisors.
Technically, every shareholder in the business is responsible for the same liabilities of the business including paying taxes and absorbing additional costs. Do our employees intend on putting money back into the company as their share of ownership? Probably not. They want upside, not downside.
If we can’t buy back the equity from folks who have left, over time we may find ourselves with swaths of equity holders who aren’t contributing any ongoing value (they left years ago) yet are still eating up valuable equity that could be used for raising more capital or awarding current employees. Not to mention working for people who don’t work there anymore is a bit disheartening.
After reading all of those potential challenges we may say “Woah! That’s bananas. Let’s definitely not give away regular equity!” And we may be right, but let’s use these challenges as the backdrop to understand why startups consider Stock Options and Phantom Equity as alternatives to some of these challenges.
When startups want to hand out stock benefits without many of the stock liabilities – they choose Stock Options. A Stock Option is a contract that provides the holder the option to buy stock at a later date, typically in the event that the company is sold or goes public.
Since the Stock Option itself is just an option to buy stock, not the actual stock (or equity), many of the downsides of giving away actual equity shares are mitigated in the short term. However, once the stock option is exercised, the unit holder then owns regular equity (in most cases) and many of the challenges of having folks who are in the Cap Table (See “Key Terms”) all become apparent.
When to use it
When we want to offer the benefits of equity while mitigating some of the consequences of handing out regular equity.
Most Stock Options have something called a “strike price” (or “exercise price”) which means the price at which the holder can purchase their options. For example, if the Strike Price were $1, we would have the option to buy stock in the company for $1 per share.
Startups will issue stock options with a strike price so that new employees can benefit from the increase in value of the company. If we join the company with a strike price of $1 and the value of the company never exceeds $1, chances are we’re not going to enjoy any benefit because the company didn’t “improve in value” during our tenure.
Stock Options hold a handful of key benefits over handing out regular equity so let’s focus on those first:
Unless the stock option is exercised, the holders will typically have no specific rights within the company such as voting or other control-based issues. This is typically by design because we don’t want a ton of people who have no actual ownership stake to have direct control.
If an employee leaves and decides not to exercise their options (which will typically have a monetary cost associated with the Strike Price) then those options are forfeited, and the stock goes back into the kitty to reward future employees.
Being granted Stock Options isn’t a taxable event until the options are exercised, at which point a whole slew of taxable challenges present themselves which we’ll need to familiarize ourselves with. What’s important here is that the taxable consequences won’t typically trigger until the options are exercised, which would only likely happen if there was a sale to offset the tax liability.
Fortunately, the concept of “stock options” has become standard fare within the startup world and therefore even if a potential recipient has never actually received a stock option before, they will most likely understand what it is.
Generally speaking, the benefits of issuing stock options tend to outweigh the costs, but that doesn’t mean there aren’t important considerations with issuing stock options. Let’s take a look at a few of the challenges.
If someone works for the company for 4 years, leaves without exercising their options, and the company sells 3 years later, they may receive no benefit at all. That could be a tough pill to swallow for folks and may not align with how we want to compensate people. (Note, there are some ways to mitigate this, but things get more complex.)
In order to set a Strike Price at which the employee would pay for their option, we would need to know what the valuation of the company is (to price the option). This may be very difficult to do at this stage, and we run the risk of pricing it too high or too low.
This is less likely than with handing out regular equity (because everyone will automatically “just own” regular equity) but in the event that we have people that exercise their options but do not materially participate going forward, we may begin to accumulate a dormant cap table. We’ll talk about this problem a lot more later.
Overall, stock options are a great way for us to provide financial upside in the event of a sale or public offering. That said, they aren’t the only way we can accomplish this goal. We still have another way of offering upside without necessarily having to hand out equity. We call this “phantom equity”.
Aside from sounding like a really cool version of equity, “phantom equity” or “synthetic equity” is simply a contract between the unit holder (employee, advisor, et al) and the company. The reason it’s called “phantom” or “synthetic” is that it works to achieve the same outcome – paying out a share of upside – without converting to actual equity units.
Phantom Equity works very similar to a stock option in that it is typically only “exercised” when the company is sold or goes public. It can also be modified to help make cash distributions (dividends) but that’s a whole other discussion.
If Derek Zoolander is issued 10,000 shares of the company in Phantom Equity, and the company has 100,000 total shares outstanding, he will receive 10% of the payout if the company sells.
The reason we might choose to issue a Phantom Equity plan may have a lot to do with how we want to maintain long term control of the actual equity in the company, ranging from who will have ownership rights (like equity holders do) to how easily we want to manage the program long term.
When to use it
Phantom Equity’s benefits are really the inverse of many of the painful drawbacks of issuing regular equity or stock options:
Because phantom equity is a contractual right, not an equity stake, we can issue the benefit of upside without having to issue actual equity ownership. This is particularly important if we want to separate “ownership structure” from “upside structure”. We may want our employees to get all the benefit of upside, but not require them to materially participate in the ownership of the company.
A significant challenge in granting equity is that it has a real market value which is often taxable upon transfer. A phantom equity unit is the “contractual right to a profit” but isn’t an ownership of any actual “gain” unless money is exchanged. For example, a salesperson doesn’t get taxed on how much commission their comp plan “might” earn – they are taxed when they are actually paid something.
Since phantom equity isn’t actual equity ownership of the company, technically the Cap Table never changes. The same owners are the same owners. That said, there could still be a liability to the company if the phantom equity holders leave and still have provisions in their agreement to be paid out for some extended period of time. This is known as a “lookback period” and we’ll cover this in detail in Phase 4.
Once again, many of these benefits are particularly useful to founding teams that would like to maintain control of the equity membership of the company long term. This tends to be common amongst companies such as professional services firms or closely-held private businesses (not necessarily small ones) that don’t anticipate adding lots of outside members such as investors.
A lot of the challenge around phantom equity begins with a lack of understanding in the marketplace. Unlike regular equity and stock options which everyone has heard about, chances are when we hand a new employee an offer of “phantom equity” they will scratch their heads at first.
Similarly, investors will almost certainly balk at taking phantom equity over regular equity. However, that doesn’t mean we can’t offer investors regular equity and employees phantom equity. It’s not one or the other.
Investors aren’t going to be interested in phantom equity because they very much want both ownership and the rights that come with equity – and deservedly so. We can still take on investors but we would need to offer them regular equity.
We may find that potential employees and partners ask a lot more questions about what a phantom equity plan is than the value of their grant. We would need to be prepared to have a standard explanation of how the program works.
Unlike regular equity gains which in the United States enjoy a typically lower rate of taxation (“capital gains tax”) than regular income tax, any benefit paid out under a phantom equity program is simply regular income to the recipient.
The one other caveat worth mentioning around phantom equity is that not every attorney understands it either. If we’re interested in setting up a phantom equity plan, we’ll want to work with an attorney that is well-versed in this particular type of program so that they can properly guide us through the inner workings.
During formation we probably only need to worry about the Founding team who will likely all be equity holders. We’re going to consider some provisions amongst that team around the “vesting schedule” of that equity (in the next section) and some provisions for how to manage that equity (in Phase 4) but we’ll certainly begin with regular equity no matter what.
We’ll start with equity for the original owners and make a decision as to whether we want to issue stock to employees as “stock options” or “phantom equity”.
If we can’t agree on or don’t have an immediate need on how we issue incentive stock to future contributors, that’s OK. We can set that program up later when we feel we have a need to think through it thoroughly.
That said, we do need to make a few decisions about how we want to set up the rest of our structure, so let’s get familiar with the big decisions.
Vesting is a way to allow members to "earn" their stock over some period of time or per specific milestones. A common "4-year vesting schedule" means that a member of the company will earn 25% of their stock per year over a total of 4 years. This is the equivalent of getting paid over time based on our contribution, like a paycheck, versus getting our 4-year paycheck up front and hoping things work out.
Think of it like this - as co-founders there are two ways that you and I can divide our stock. We can each take our stake all up front and be done with it. That's how most startups do it because it's simple, but that doesn't mean it's a good idea. Everyone in the 70's let their little kids ride in the front seat of the station wagon with no seat belt, but that didn't make it a good idea.
Or, because we took the time to seek out a course on how to split equity properly, we can learn why smart Founders (and the investors who back them) prefer to setup a vesting schedule to earn their stock over time!
(If you read that and knew it was a Karate Kid reference, you’re cool in my book).
Vesting is commonly used among funded startups to allow members to earn their stock over time. This provides an incentive to stick around, but it also provides a mechanism to be sure that if folks bail (or get fired) that a huge swath of equity wasn't arbitrarily awarded without earning it.
So why would the two of us wily co-founders want to vest our own equity?
Simple - to make sure we both do what we think we're going to do over a the long haul. Without vesting stock we run into the problem of having distributed equity without being sure it had been earned - and that goes for Founders as well as employees.
If everyone is doing what they said they were going to do - vesting shouldn't be a problem and it should go unnoticed. However if problems arise (someone is let go, for example) then vesting becomes really important because we haven't given away all of the stock without a mechanism to return it fairly.
Assuming we understand the value of vesting, we have 3 big decisions to make to determine how vesting will work. Let's do a quick fly-by and then we'll go into more detail:
Vesting works on what's called a "vesting schedule" which simply means the amount of time until all of our stock is earned.
In the example we used earlier, if we have a "4 Year Vest" of our equity, that means at the end of year 1 we will own 25% of our total 100% stake. At the end of Year 2 we will own a total of 50% and so on. We have to stick it out for 4 years to earn 100% of our stake using a time-based schedule.
The two most common types of vesting schedules are "time-based" and "milestone-based".
Equity is earned over a fixed period of time (typically in years) with a specific percentage vested at each date. This is the most common way equity vests.
Equity is earned based on the member achieving certain milestones. For a salesperson, for example, the milestone could be a certain sales target. For a software engineer, it could be a specific release date of the company's product.
There are no hard and fast rules on how long a vest should occur or what milestones we can choose. Just like negotiating compensation, we want to find a balance between being fair and “well-earned”. If we think that 2 years is enough time for the Founders to have earned our stock, so be it.
Pick a time period in which vesting will fully occur. 4 years is standard, but we can choose any period of time.
What happens if one of our Founders, employees, advisors or other members only sticks around for 2 months? Do we really want to be vesting stock to every person that may have not even made it a year? That seems like a messy Cap Table and a recipe for disaster down the road.
To combat this, we can set up a “vesting cliff” that stipulates a minimum time period someone has to be vesting before any of their stock can be granted. This is often a year, but we can set it to be any threshold we want. Most startups use a year because that seems like a reasonable amount of time that would yield a reward for anyone. If an employee stays only 11 months, for example, they wouldn’t be eligible for any stock.
Vesting Cliffs are optional but generally a good idea so that we don’t accumulate a ton of short term employee stock grants. The likelihood that these employees made a significant contribution to earn their stock in less than a year is probably low.
One caveat – we may offer stock to some contractors or non-employees that specifically don’t entail a long-term commitment, and therefore in those cases we’ll just waive the cliff provision. For example, if we contracted a designer for our Web site and decided to pay them in a one-time grant of $25,000 for their work, we would likely grant the stock all at once since there is no time-based employment condition. This would revert in most cases to a “milestone-based” award whereby teh delivered the project in order to get awarded stock.
Pick a “cliff” period during which no stock will vest until this period is reached.
The last piece of the puzzle is called “Acceleration” which covers events like “What happens to everyone’s vesting of stock if the company sells tomorrow (before everyone is vested)?” For this reason, we’ll add something called “Vesting Acceleration” which often involves a “trigger event” (such as a sale).
Acceleration is the goal, but the “trigger” is what we need to determine.
In most cases if a sale occurs (this would be a “trigger”) then everyone’s stock will fully vest or “accelerate” just as if they had waited their 4 years or met their total milestone goals. Our intent here is to make sure that members feel they are treated fairly in the event of something wonderful happening.
In reality, is it “fair” that someone who worked there 6 years will have vested as much as someone who worked there for 2 years and happened to be there during the sale? Not exactly, but if we feel strongly about that we can modify the acceleration to only accelerate one year of vesting. It doesn’t have to be all or nothing.
Pick particular triggers that would accelerate vesting and determine how much of the vesting will be accelerated.
The vesting triggers are just intended to be a stop gap in case something meaningful happens. We don’t necessarily have to add them to our plan, so these are definitely optional.
Our special considerations for stock will come down to a few important decisions. We’ll first determine whether we want to include each provision (vesting schedule, cliff, and acceleration) and then exactly how we want to modify it for our needs.
If we choose to have the stock vest - is it based on a time period or a milestone?
Do we want to invoke a period in which the stock can’t be awarded? A typical window is 1 year.
Would we like stockholders equity to be automatically vested based on a triggering event such as a sale?
We will then take these decisions to our attorneys as the basis for how we would like our agreements to be set up. These will be the 3 most important moving parts that our legal team will need to craft our team agreements.