For startups, equity compensation is a valuable tool to attract talent, conserve cash, and align employees, consultants, and advisors with the company’s long-term success. But issuing equity does not automatically motivate staff, generate loyalty, or prevent turnover. Here are four common mistakes startups should avoid when designing and administering their equity compensation programs.
Treating Equity as a Substitute for a Competitive Compensation Package
Equity compensation is often a necessary component, especially when a startup cannot compete on salary alone. However, it’s critical not to overestimate the motivational value of an equity grant. Unlike cash, startup equity is generally illiquid, and recipients may not be able to sell their shares for years, if ever. As such, when communicating about equity compensation, startups should avoid suggesting that any equity grant will have a guaranteed future value. Instead, startups should explain what is granted (such as, an option versus a restricted stock award), how vesting works, what happens when a service relationship ends, and what conditions must be satisfied before a recipient can realize any economic benefit.
Not Giving Proper Consideration to an Appropriate Vesting Schedule or Exercise Period
Vesting schedules are designed to reward continued service and align staff incentives with the company’s long-term objectives. A typical grant vests over four years, often with a one-year cliff, although the appropriate structure depends on the company and the role, with startups frequently offering a shorter vesting schedule when the service provider is an advisor or consultant.
When a recipient receives a stock option, the recipient may have only a limited period after termination to exercise vested options, and there has been plenty written from prominent tech figures that the standard 30–90-day period is unreasonable when balanced against the forgone cash compensation. If the exercise price is substantial, the holder may be unable or unwilling to exercise before the deadline. Comparatively, restricted stock awards present different considerations, including whether the issuer retains a repurchase right over unvested shares and how that right is exercised.
It’s crucial that the administrator of the equity incentive plan (most often the board of directors), establishes clear, consistent rules that align with corporate strategy and strike a fair balance of incentivizing recipients, while not overly burdening the cap table.
Failing to Strategize for Equity Needs and Future Dilution
An equity plan that works for the first few hires may become inadequate as things take off. If the company is too focused on the percentage of the company allocated to the initial pool, it may overlook future hiring needs, anticipated financing rounds, and the resulting dilution. With each financing round, it is all but a given that investors will require the company to increase its equity pool as part of a financing to avoid the investors being diluted by subsequent issuances between the financing and the follow up round(s). The important takeaway is the need to treat equity-pool sizing as part of the company’s broader capitalization strategy. Forecast anticipated hiring and grants, understand how pool increases affect dilution, and review the capitalization table before putting a game plan in place.
Not Monitoring the Approval and Governance of the Plan Itself
A well-drafted equity plan and form agreements won’t prevent downstream problems if the company does not administer them properly. Equity grants generally require appropriate corporate authorization and compliance with the company’s equity plan and grant documents, including issuance rules under the company’s governing law. In addition, the company must address federal securities-law exemptions, state-law requirements, tax reporting, and applicable accounting treatment.
Common mistakes include, but are not limited to, issuing grants before obtaining required board approval, using outdated grant agreements or an outdated version of the plan itself (if it has been amended), failing to track vesting and post-termination exercise deadlines within an organized cap table or online management platform, and not filing required federal or state limited offering exemption notices.
The key is to establish a repeatable process for approving, documenting, issuing, and tracking equity awards. Maintain accurate capitalization records, use current documents, and review the plan periodically as the company grows and its financing structure evolves. When a startup undergoes due diligence as part of a financing round or an exit, this is one area that third parties will heavily scrutinize.
Equity compensation can be an effective tool for attracting and retaining talent, but it is not a substitute for thoughtful compensation planning, clear communication, and sound management. We work with startups, founders, and boards of directors on equity compensation, corporate governance, and financing transactions. If your company is developing its first equity incentive plan or revisiting an existing program, experienced legal counsel at Archetype Legal can help ensure that your equity arrangements are structured to support your business as it grows. If you have questions, you can reach us at hello@archetypelegal.com
Disclaimer: This post discusses a general legal topic, is intended to serve as informational only, and may not reflect the most current legal trends in your jurisdiction. This informational post is not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Archetype Legal PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this post.
