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September 7, 2022

Equity Incentive Plans

Equity incentive plans are important for getting the right talent on board your venture and staying with you long-term.

An equity incentive plan is a way of offering compensation in the form of company ownership that is exempt from securities registration rules. It comes in many forms and requires compliance with several regulations so let’s take a look at how an equity incentive plan can be beneficial for your company.  For this post, we’ll assume that the equity incentive plan will be for a corporation that has authorized and issued shares of stock for such a plan (as opposed to units of an LLC).

 

Equity incentive plans are often used to compensate service providers who you want to stick around for the long term. In the early stages, companies often use equity to compensate key individuals in lieu of cash until the company gets off the ground (ie, is in significant cash flow positive territory).

 

Equity is a great way to attract talented professionals to your company. It can help build loyalty while keeping the impact on your cash flow to a minimum.  Of course, caution must be taken to avoid giving too much of a company’s equity away and usually equity given out through such an equity incentive plan is non-voting.

 

There are many types of service providers to whom you may offer equity. The roles often include C-level executives, advisors, consultants and independent contractors. Most service providers will be eligible to receive equity from your equity incentive plan and appreciate the ownership opportunity.

 

The amount of equity you give each of your service providers out of your equity incentive plan depends on many things.  Proper consideration should be given to the total amount of equity in your equity incentive plan. You want to have enough to give away to service providers but not so much that you and other shareholders are unnecessarily diluted.

 

When determining how much equity to set aside for your plan, you should establish what your company is worth. Section 409(a) of the Internal Revenue Code regulates nonqualified deferred compensation paid to service providers, such as equity out of an equity incentive plan. To avoid negative tax treatment and excise taxes, the company will need to ensure that the equity is issued with an exercise price that is at least equal to the fair market value of the underlying stock on the date of the grant. Pursuant to Section 409(a), the Internal Revenue Service requires that a non-publicly traded company determine the fair market value of its stock by the “reasonable application of a reasonable valuation method.”  

 

There are three 409(a) “safe harbors” available to companies that the IRS will presume to comply with409(a). First, a company can hire a professional to conduct an independent appraisal. An Independent appraisal is reasonable if it is conducted within 12 months of the relevant transaction and is performed by a qualified independent appraiser.

Second, the company could base a valuation upon a formula that, if used as part of a non-lapse restriction for the stock, would be considered the fair market value of the stock (for example, a company’s right of first refusal to purchase employee shares at a fixed price).

 

Third, an internal valuation is available to companies that have been active for less than 10 years and that have no class of equity securities that are publicly traded. Such valuation must be reasonable, made in good faith, evidenced by a written document, and produced by a person with significant knowledge and experience in performing similar valuations.

 

When determining the number of shares you would like to reserve for issuance under your plan, playing out scenarios with your cap table becomes an important tool to see what the implementation of the plan does to your overall equity structure over time.

 

For example, most early-stage companies reserve about 15% of their fully-diluted equity for issuance under their plan. Although the equity incentive plan may not affect voting control, getting an understanding of your fully-diluted equity provides additional feedback when determining the amount to reserve in the plan.

 

Once you establish your plan, there are several means by which you can distribute the equity out of the plan. The most common vehicles are stock option grants, restricted stock sales and stock appreciation rights. Stock option grants are options that can be exercised at a set price to purchase shares after the option vests, presumably when the stock price has appreciated in value. This is distinguished from restricted stock, which is purchased at fair market value when granted. Stock appreciation rights, on the other hand, enable the holder to receive payment in an amount equal to the excess of the fair market value of the stock on the date the right is exercised over the fair market value of the stock on the date the right is granted.

 

Equity grants might also include a company repurchase option on restricted stock grants, with the grants being generally non-transferable. Note that all grants are typically approved by the Board of Directors.

 

Most stock incentive awards will be subject to vesting over time. This is to ensure that your service provider stays with your company until his/her grant is fully-vested (which should be a significant period of time). A typical vesting structure might be a one-year cliff where 25% of the grant is vested only after the service provider has been working for a full year, and the remaining 75% vesting in monthly increments over the next 3 years.

Afissio regularly establishes equity incentive plans for its clients. For any questions or more info about setting up your equity incentive plan, contact us at info@afissio.com.

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