How to Create Your First Equity Plan in 10 Steps

June 19, 2024

Equity plays a crucial role in a startup's total compensation package, but structuring a plan demands careful decision-making around several key factors, such as:

How much equity in the company should be reserved for employees?

Should all roles be eligible for equity or just senior team members?

Should restricted stock units (RSUs) or stock options be granted?

Should equity be granted as a one-off for new hires, or should refresh and promotion grants be considered to reward performance?

Should the equity strategy change as the company grows?

With these considerations in mind, follow this step-by-step guide to establish your company's first equity incentive program, ensuring it aligns with your company's unique goals and aspirations.

Step 1: Clarify the Company's Objectives and Vision

Determine what you aim to achieve with your equity program, whether it's attracting top talent, retaining key employees, aligning interests with company success, or a combination of these factors.

Step 2: Decide How Much Equity to Reserve for Employees

This requires a delicate balance between incentivizing talent and safeguarding equity for future growth. Typically, founders start this process by determining the overall percentage of equity earmarked for an employee share pool, which usually ranges between 5-15% at early stages. The aim is to strike a balance between maintaining company ownership and providing employees with meaningful stakes.

Using a bottom-up hiring plan, founders then allocate equity grants based on role and seniority. This process involves adjusting grants for new hires and considering refresh grants to reward performance. It's essential to revisit this allocation strategy periodically, especially before each funding round or strategic shift.

Step 3: Determine Eligibility

This is a strategic decision that hinges on the company's philosophy and objectives and involves considering whether all employees should receive equity, if amounts should vary based on role and seniority, or if it should be reserved for senior team members. Share pool constraints and dilution limits may force private companies to limit eligibility for equity grants.

Here is an overview of the different approaches:

Approach

Description

All Employees or Selective

Offering equity to all can attract and retain talent. It also encourages teamwork, creativity, and shared accountability, as employees at all levels work together towards common goals but dilutes ownership. A selective approach can reserve equity for key contributors.

Equity Variation Based on Job Role, Seniority, and Contribution Level

Equity variation based on job role, seniority, and contribution level involves tailoring equity amounts to reflect differences in employees' roles, levels of experience, and contributions to the company's success.

In this approach, employees in more senior or critical roles may receive a larger proportion of equity compared to those in junior positions. Likewise, individuals who have demonstrated exceptional performance or contributed significantly to the company's growth may be granted a higher share of equity.

This strategy aims to align equity distribution with the perceived value each employee brings to the organization, motivating employees to excel in their roles and fostering a sense of fairness and recognition within the workforce. It also helps to retain top talent by rewarding individuals who make substantial contributions to the company's success.

First Hires and Top Leaders

First hires and top leaders often receive special consideration due to their role in shaping the company's early success and the risk they undertake. Equity granted to them should reflect the stage of the company, traction, potential upside, and compensation package negotiations.

Variance Across Job Functions and Levels

Equity varies across roles and seniority levels. Product and engineering roles may receive higher equity due to their direct impact on product development and company growth. Level multipliers and reliable equity benchmarks can guide fair equity distribution.

Step 4: Choose the Type of Equity

When private companies consider equity instruments, they typically evaluate several options, including stock options, RSUs, and phantom stock. Each award type carries distinct implications for both the company and employees, including tax considerations, vesting schedules, and liquidity preferences.

Stock options grant employees the right to purchase company stock at a predetermined price (the exercise price) within a specified period. Startups and early-stage companies often prefer them due to their potential for significant upside and flexibility. However, employees must typically exercise their options and pay taxes upon exercise, which can present liquidity challenges.

RSUs represent a promise to deliver company stock at a future date, subject to certain vesting conditions. Unlike stock options, employees do not need to purchase RSUs, and they receive shares outright upon vesting. RSUs are commonly used by mature private companies and are simpler for employees to understand, but they may have different tax implications and typically require a liquidity event for employees to realize their value.

Phantom stock is a cash or stock bonus plan in which employees receive hypothetical shares that track the company's stock price. Unlike RSUs, phantom stock does not represent actual ownership in the company, but employees receive cash or stock equivalent to the share price or appreciation in the company's value over time. Phantom stock plans can provide employees with a sense of ownership and alignment with company performance without diluting actual equity ownership.

When choosing between these award types, companies must consider factors such as their stage of growth, financial resources, employee retention goals, and desired level of complexity.

Step 5: Determine the Vesting Schedule

The vesting schedule details when employees will become eligible to exercise or receive their shares and should align with the company's goals and objectives. Vesting schedules can be based on time or milestones. Gradual vesting, such as monthly or annually over a specified period, is most common. For example, a four-year vesting schedule with a one-year cliff (no vesting until the first anniversary) followed by monthly vesting thereafter is a common structure.

Step 6: Establish the Grant Structure

In this step, the company decides whether equity grants will be one-time offerings for new hires or distributed periodically through refresh and promotion grants. Refresh grants play a vital role in retaining talent and acknowledging ongoing contributions. However, they typically constitute a smaller percentage of initial awards compared to public companies and are less frequently granted in private companies because they can become quite “expensive” (i.e., dilutive to the option pool). Once the expectation of a retention equity program has been set with employees, it can be damaging to morale to take it away when it does become too expensive, erasing any benefit the program might have had in earlier days.

Step 7: Create the Grant Guidelines

Using equity benchmarks helps companies establish a framework for awarding equity to employees. This framework ensures fairness, consistency, and alignment with the market. While many companies aim for the market 50th percentile, target ranges often depend on available shares. Companies may adopt either a detailed, role-specific approach or a simpler base salary multiplier approach to determine equity grants. The detailed approach breaks down equity ranges for each role, seniority level, and location, resembling a salary band structure. In contrast, the simpler approach involves applying a base salary multiplier based on factors like job level or role.

Step 8: Draft the Plan Documents

Drafting the plan documents for an equity incentive program involves creating formal documentation that outlines various aspects of the plan, such as eligibility criteria, grant structure, vesting schedules, and other terms and conditions. These documents typically include a plan summary, grant agreements, and any other relevant policies or procedures. It's essential for these documents to undergo legal review to ensure they comply with relevant laws and regulations governing equity plans. This legal scrutiny helps mitigate potential risks and ensures that the plan operates within legal boundaries, safeguarding the interests of both the company and its employees.

Step 9: Communicate the Program

Startups must ensure that employees appreciate and understand their equity grants. This requires thorough education and transparent communication on equity mechanics, its pros and cons, and its ties to company success, including funding rounds and future liquidity events.

Step 10: Administer and Manage the Plan

Establishing processes for plan administration is crucial for effectively managing an equity plan. Consider using an equity management system for efficient plan administration.

Visit the NASPP’s Solutions Showcase: Cap Tables to learn more about cutting-edge solutions and tools tailored to streamline plan administration.

Designing your first equity incentive program marks a significant milestone in your company’s journey. It's an exciting endeavor that not only adds a new dimension to your compensation structure but also aligns the interests of your employees with the long-term success of your business.

By Robyn Shutak
Partner

Infinite Equity