If you’re a founder or operator of a startup, you know that building a successful company requires more than just a great idea and hard work. It also involves navigating the complex landscape of equity and compensation. One crucial tool that can help you achieve your goals is a well-structured equity incentive plan.
In our previous article, The Founder’s Guide to Employee Stock Options, we uncovered what stock options are, why they’re offered, and how they work. In this guide, we’ll be sharing everything you need to know about how to adopt an equity incentive plan.
What is an equity incentive plan?
An equity incentive plan is a written document that governs the granting of equity awards to employees, advisors, consultants, and board members.
When to adopt an equity incentive plan
Ideally, the founding team should adopt an equity incentive plan soon after a startup is formed and right as the first employees begin. This has several advantages:
- Attracting early talent: A well-structured equity incentive plan can be a powerful tool for attracting top talent to a new venture. The promise of an attractively-priced equity grant can incentivize employees to join the company at an early stage. It can also entice advisors and consultants to give their time to a newly created, unproven company.
- Aligning interests: Equity grants align the interests of employees with the company’s growth and success given they have a personal stake in the company.
- Cost-effective compensation: Lastly, equity grants are a cost-effective way to compensate employees, especially during the early stages of company growth when cash flow may be limited.
Key considerations
1. Equity pool size
The equity pool is the designated portion of a company’s shares that are reserved for issuance under the equity incentive plan, under any award type. It is generally a set number of shares that, as a whole, represent a percentage (often 10-20%) of the company’s total number of shares on a fully diluted basis. The size of the equity pool is approved by the board of directors and stockholders at the time the equity incentive plan is initially adopted and can be increased or decreased by board and stockholder action in the future. Equity pools often get adjusted (or “topped up”) in connection with equity financing rounds.
💭 What does fully diluted mean? “Fully diluted shares” generally represents the total number of common shares that are issued or issuable upon the conversion of any convertible securities, including preferred stock, convertible notes and SAFES, and the exercise of any outstanding contracts or promises to purchase or issue shares, including stock options, RSUs and warrants.
2. Types of equity grants
Equity grants, or awards, can come in multiple forms, including:
- Stock options grant the holder the right to purchase company shares via exercise at a predetermined price (i.e., the exercise or strike price) within a specified period of time. Stock options are generally subject to vesting, with some grants being exercisable ahead of vesting;
- Restricted stock awards grant shares of company stock, subject to vesting conditions. RSAs allow the grantee to become a stockholder as of the date of grant, with the voting rights attributable to the stock subject to the RSA; and
- Restricted stock units provide a contractual right to receive shares of company stock in the future, subject to vesting conditions. RSU holders generally do not have standard stockholder rights until the RSU vests and the underlying shares are issued.
In terms of best practices, many companies will maintain a generally consistent award type, especially with respect to employees.
3. Vesting schedules
Vesting schedules are a predetermined set of rules that outline how a grantee vests in, or “earns”, their equity grant. A vesting schedule will begin running on a specific vesting commencement date, which is approved by the board at the time of the grant and is often an employee start date or the grant date itself. Common features of vesting schedules include:
- Cliff period: A waiting period before any options vest (e.g. one year from employment start date);
- Time-based vesting: Options vest over a period (e.g. monthly, quarterly, annually), with or without a cliff period; and
- Performance-based vesting: Options vest based on achieving specific performance goals.
The most common vesting schedule for non-founder employees is time-based at four years long, with 25% vesting on the one-year anniversary of the vesting commencement date (the cliff), and the remainder vesting in equal monthly installments over the 36 months thereafter.
4. Exercise price
Also known as the “strike price”, this is the price at which grantees can buy the shares. Typically, the exercise price is set at the fair market value of the company’s stock on the grant date. Companies issuing equity to US-based persons should have a third-party 409A valuation prior to setting the exercise price for any grant.
5. Legal counsel
Consult with legal counsel to set up your equity incentive plan. Counsel can provide you with the applicable documentation to operate your plan (such as stock option award agreements) and help ensure that your plan complies with applicable corporate, securities and tax laws and regulations, and accounting rules and guidance.
What Happens After You Create Your Equity Incentive Plan?
1. Obtain Necessary Approvals
Before granting any awards under an equity incentive plan, the company should secure approval of the plan, its terms and the size of the equity pool from the board of directors. Depending on a company’s jurisdiction, stockholder approval may also be required to comply with securities or tax rules.
2. Grant Equity Awards
All equity awards should be approved by the board, or a duly-appointed committee acting on its behalf. Once approved, equity award agreements should be completed and distributed to each grantee.
3. Administer the Plan
- Record-keeping: A company should maintain accurate records of option grants, exercises, and forfeitures. Using equity management software like Mantle helps automate this process for easy administration.
- Tax reporting: Comply with tax reporting requirements for both the company and employees.
- Employee communication: Clearly communicate the terms and benefits of the plan to employees.
Additional tips
- Start Small & Simple: Begin with a smaller equity pool and keep the plan simple and easy to understand. Avoid overly complex terms or conditions. As the company grows, you can consider expanding it.
- Review and Update: Periodically review the plan and make adjustments as your company’s circumstances change.
- Leverage Equity Management Software: On Mantle, you can generate your company’s equity incentive plan in a few clicks and manage equity grants in real time as your company grows.
How to Add an Equity Plan in Mantle : Step-by-Step Guide
Streamline equity management with Mantle.
Disclaimer: This blog post is provided as general information to clients and friends of Mantle. It should not be construed as, and does not constitute, financial, legal or tax advice on any specific matter, and employers and employees should always consult their professional advisors, accountants or attorneys as needed when considering decisions or actions that may impact your business or personal interests. Mantle does not assume any liability for reliance on the information in this blog post.