If you’ve recently started a company or are planning to in the near future, there are a number of important decisions you’ll need to make.
One of those decisions is how to give your early employees or consultants the right type of equity compensation.
You need motivated, high-performing talent to help you launch your startup. It’s important to choose the right method of sharing equity with your founding team so you can attract the best people, build a culture of commitment and ownership, manage limited cash flow in the startup stage, reduce turnover, and potentially give the people who believed in your mission and worked diligently to execute your vision a massive payoff in the future.
But which option is right for you: stock options or equity?
In this post, we will explore the benefits and key factors of each option so you can feel confident in how you choose to compensate your startup team.
Stock options vs. equity – what’s the difference?
You can’t make an educated decision about equity compensation without understanding the nuances of your options.
Let’s break it down.
Stock options give employees or contractors you work with to get your startup off the ground the option to buy shares of the company’s stock in the future.
Stock options are essentially worthless when they are granted, but they can become incredibly valuable over time.
When you give your employees or contractors stock options, you give them the ability to buy stock in the future at a set price. This set price is called the “strike price.”
You’ll typically set a graduated “vesting” term for the stock options, gradually giving the recipient the right to buy them out. This may look like 25% of the stock options vesting each year over a 4 year period, with 100% of the stock options fully vested after 4 years.
When the stock options vest (ie. when your employee can exercise them), they are able to buy at the original strike price. If your company’s value has significantly increased over the years, this can result in a larger profit for the stock option holder.
Stock options give your employees a chance to make a lot of money in the future without giving them a direct share in the company from the outset. The value of the stock options is based on the company’s growth between when the stock options are offered and when they vest.
Equity shares, on the other hand, give employees or contractors immediate ownership. Equity can be given in full or over a vesting term similar to stock options.
With equity shares, you’re giving your team direct ownership of the company. This may include things like voting rights, dividends, and profits from a future sale of the company.
When to consider stock options
If you’re trying to decide how to reward and compensate your startup employees or contractors, you want to make sure you choose the option that balances their needs with your business needs. We want an arrangement where everyone wins.
Stock options are a great choice when you want to:
Manage cash flow: If your startup has limited cash resources, stock options are a great way to reward your team without requiring any upfront funds .
Retain the best talent: Because stock options vest over a number of years, they can be a great incentive to keep your top-performers and founding team around until they are able to cash in on the bonus.
Encourage results: Stock options are directly tied to the success of the business, so recipients can be more motivated to work harder and meet KPIs because it means more money in their pocket.
When you’re at the seed stage and just getting your startup off the ground, stock options can be more desirable than direct equity because the future value of the company is still so uncertain.
There may be tax incentives to offering stock options as well, especially if you choose to offer Incentive Stock Options.
Some downsides to offering stock options?
Liquidity can be an issue. If your company doesn’t go public or isn't acquired, it could be difficult for your employees or contractors to sell their shares and cash in.
Issuing stock options does dilute your ownership over time, but it’s typically a more controlled and measured dilution compared to direct equity grants.
When to consider direct equity grants
Direct equity – giving your team direct, immediate ownership in the company – can be a powerful incentive and lucrative reward.
You may want choose equity grants when you are:
Making key hires or filling senior roles: If you want to attract top talent or fill your C-suite with the best performers, direct equity creates true partnership and more of a stake in the company.
A later-stage startup: Once your company has a clear value and your employees can understand the value of their ownership (with a predictable path to acquisition or an IPO), this type of equity compensation can feel more valuable than stock options.
Trying to create a sense of ownership: When you want your team to be fully committed and take extreme ownership of your startup’s success, equity grants give them a more serious stake in the company’s results.
There are tax implications to consider when offering equity shares. Make sure you work with your CPA to clearly understand the type of grant, the vesting schedule, and the company’s valuation at the time of the grant so you can educate your employees about how the grant will affect their taxes.
Some downsides to offering equity grants?
You give up more control when you offer direct ownership in your company. Recipients can be entitled to vote on decisions and receive dividends, and you’ll dilute your ownership faster than you will with stock options.
Equity grants are also more complex than stock options which can complicate your cap table and make it more challenging to understand who owns what.
Stock options vs. equity – which will you choose for your startup?
Based on your startup stage, cash flow, desire for control, and goals for your team, you’ll need to choose how to attract and reward the individual contributors, managers, and C-suite executives that will propel your startup to success.
In general, stock options are more common for early-stage startups that have limited cash flow and want to incentive employees to stick around for the long haul while equity grants are a better option for late-stage startups who need to make key hires for important roles and have a clearly established value.
Using the information and comparisons featured here, you should be able to make the right decision for your company.
We always recommend working directly with a business attorney to ensure everything is in order and you understand all the implications of your decision before offering any type of equity compensation.
If you’re looking for a qualified, experienced business attorney to support your startup, we would love to talk to you
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