Size of the Equity Pool: Who Gets It, and How Much?
Before a company undertakes an equity program, beyond the truistic question of “who gets it,” the central legal question should be “how much,” specifically, the size of the equity pool. For a small or otherwise family-owned company, there may be a lot of flexibility, as equity grants may be part of a succession plan (to children or otherwise). Conversely, for a PE- or VC-backed company, the fund(s) will largely have the final say in how much equity is provided, because by its nature additional equity is dilutive to the fund; in these contexts we find it is rare for more than 10% to 20% to be available to employees. In either case, to avoid a slippery slope of granting too much equity—or, as bad, having the fund(s) come back and say the equity was not validly approved—having a business plan in mind for the next year or two will help the company and its advisors determine a reasonable size for the option pool that does not unnecessarily dilute early-stage shareholders or overly limit the ability to attract future investors or employees. For example, if the company anticipates bringing high-profile individuals to its executive team in the coming year and expects that those individuals may require large equity grants, the size of the pool may need to be larger from its inception than that of a company who anticipates making only a small number of grants to new employees.
Type of Equity
Though the brevity of this article precludes covering the entire laundry list of equity options above (including ESOPs, which are topic of their own!), we find that the two most frequent means of granting equity are via direct purchase of stock or direct issuance of profits interests. In the direct purchase of stock scenario, employees are given the opportunity to subscribe—i.e., use their own money—to buy shares of the company. By nature, this opportunity is almost never mandatory, but rather is framed by the company as a chance for employees to participate in the company’s upside (versus most closely held companies, which would not offer such an opportunity for the dilution reasons above). Occasionally, companies may grant stock—rather than have employees subscribe—which is where the company provides the shares to employees for “free.” However, both the company and benefiting employee(s) should discuss this scenario with their accountants, as a grant in this context will usually be a taxable event; for example, a grant of $100,000 in stock to an employee without any payment by the employee will often be treated as compensation or compensation-like to the tune of the full $100,000.
The other common means of providing equity, principally in partnerships or limited liability companies, is through the granting of profits interests, which provides the employees with an interest in the company’s future earnings and profits. Unlike other forms of equity, an employee’s receipt of profits interest does not result in immediate taxable income if documented properly, including the submission of a protective 83(b) election to the IRS in a timely fashion to ensure that the fair market value of the profits interest will be deemed zero even if certain IRS safe harbors for profits interests are not fully satisfied. Before embarking on such a structure, companies should seek advice from their outside tax and legal advisors to confirm that this structure will be both legally compliant and advantageous for the companies’ goals, since in most cases a critical component of profits interests is that the recipients cannot be considered employees by the IRS, but rather they are considered partners of the company (and thus will receive K-1s rather than W-9s). Accordingly, some companies set up separate intermediate partnerships or limited liability companies for purposes of providing the profits interests.
Vesting and Monitoring
Most types of equity can be structured in a way to vest over time or, based upon the company’s performance, as a further incentive to keep the employee recipients engaged. For example, a company could have a percentage of the equity vest quarterly or even monthly over the term of the grant, or more creatively, tie the vesting of an individual’s grant to the satisfaction of a particular employment condition, such as the successful migration of a company’s IT system or the attainment of a defined number of sales. Keep in mind that the more complex the vesting schedule, the more challenging monitoring it will be—especially if a significant number of employees receive equity—over time should employees leave the company. The equity should also have components that either provide for repurchase (in the case in particular of subscribed equity) or forfeiture (often in the case of profits interests, as well as phantom equity) upon termination of employment. The devil is in the details on the repurchase and forfeiture scenarios as the reason for the employee’s departure may affect the terms of the repurchase or forfeiture.
If you or your company are considering providing equity to employees, in general, doing so is a great step towards helping your employees feel happy and invested. One final recommendation we have—whatever the type of equity program—is to make sure that only certain individuals at the company have the authority to provide offer letters with equity grants to employees, and that they are likewise charged with tracking each signed grant and having a precise awareness of the outstanding size of the option pool before and after each new grant. Those same individuals should regularly (quarterly or semi-annually) report to the executives and/or the fund(s) to make sure that the program is achieving its intended objectives.
With any questions, please contact Will Henry or Bekah Raines.
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