Figuring Out How to Divvy Up Startup Equity
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Q: I am looking for advice when setting up equity option pool for an LLC. What are the pitfalls and what factors should I consider?
A: There is no universal approach for setting up an equity pool for an LLC. However, there are a few standard best practices that should guide your decision making. Here are the top three:
Vest equity over time. Most technology startups issue equity that vests over time to align compensation with the long-term goals of the company. By vesting, I mean the person doesn't receive the options, or equity, immediately, but rather on a schedule -- they receive a little bit the first year, more the second year and so on. The most common equity formulation allows options to vest over four years with 25 percent vesting after one year of employment and the remainder vesting in equal monthly installments over the next three years.
Vesting dates can also be tied to business milestones as an incentive for employees to achieve specific operational goals.
Be prepared for some employees to ask for an “acceleration” clause in their compensation package. This allows an employee’s equity to vest early in certain scenarios, most often in the case of early termination without cause or if the startup is sold or acquired. In practice, an employee could end up leaving the company after a short time, yet still reap the benefits of a long-time employee. It might still make sense to offer this to select employees, but it’s not something that should be offered casually.
Distribute equity fairly. In most cases, the startup’s board of directors or board of governors administer equity plans and will determine the number of shares underlying the award and its specific vesting terms. As companies mature, it is critical to create a structure that gives similarly-situated employees options within the same general range. For example, a person with a vice president title may get between .4 and .6 percent, managers between .2 and .4 percent and other employees less than .1 percent. Keep in mind that although almost all companies regard equity allocations as highly confidential, it is not uncommon for employees to share this information with each other.
Consider the tax implications of each structure. There are three main equity structures for LLCs -- a profits interest, an option and phantom equity.
Profits interests can be defined as a partner or employee receiving a certain percentage of profits without providing capital. So the person can make a lot of money not taking a lot of risk.
Profits interest have many tax advantages, as it can be taxed under long-term capital gains. That said, profits interest can also incur unnecessary taxes to employees if the “floor” of the award is not set to fair market value. If the floor is set too low, for example, an employee could end up with additional taxable income to report. For instance, if the floor is set at $10 and an employee exercises at $100, he will pay have to pay taxes on $90. On the other hand, if you set the floor higher, at like $90, the employee will only have to pay capital gains of $10. May sound confusing, but as a founder, you just need to ensure your floor is the correct value, otherwise employees will have to pay higher capital gains when they sell.
Profits interest also introduce additional paperwork since employees who hold them are officially members of the LLC. As members of an LLC, they are required to report any income gains or losses resulting from their stake in the company. This also means that founders must hand over some control of the LLC to others, which may be viewed as a drawback.
On the other hand, employees with stock options, or shares of the company, don’t get membership into the LLC until they exercise their options, making this structure simpler from an administrative perspective. However, the LLC should still make sure it sets the options to fair market value so that employees receiving options don’t incur unnecessary taxes.
The last option is phantom equity, a form of compensation that awards employees cash based on a fixed number of stock shares. For example, in December, a founder states it will pay a bonus worth 20 shares for January. When January rolls around the founder can pay the cash value of the share (i.e $10 a share, which would equal a bonus of $200), without giving up any shares.
Phantom equity is sometimes considered for its flexibility, but it has few tax advantages. It also doesn’t provide employees with LLC membership, which appeals to many founders who seek to maintain a greater level of control over the LLC.