By Omoruyi Edoigiawerie, Esq
Last week, I addressed equity in start-ups from the perspective of the founders and investors. This week the focus is on equity compensation from the perspective of founders as employers and the employees’ especially technical and senior-level employees who will help grow the start-up.
It bears repetition that one major challenge that start-up founders face at the onset is finance, but besides finance, they also are faced with the challenge of employing capable hands to help build the company.
After getting initial funding from investors and giving equity in return, they have limited choices as they seek to ensure sustainability in product development while ensuring that they don’t break the bank to pay employees what is due them.
It is, therefore, often a herculean task for start-up founders to pay employees competitive wages, especially the skilled ones whose remuneration could be quite substantial and capable of eating deep into the company’s pocket. This is where employee equity compensation comes to the rescue.
Many start-ups lack cash flow and would rather invest cash flow into product development, this makes equity compensation an option to attract high-quality employees.
The basic idea behind employee equity compensation is to offer employees a share of the company’s future profits in exchange for reduced or even zero salaries. Employee equity has also proven to be a very effective means of battling the attrition challenges that start-ups face especially concerning key employees who are leading or driving the product development process.
What is employee equity compensation?
Employee equity compensation is non-cash pay that represents ownership in the company. This kind of compensation can take many forms including performance shares, restricted stock, and options. The main idea behind offering equity compensation is to allow the employees of the company to get a share in the profits through appreciation. This encourages staff retention, especially if there are vesting requirements.
Employee Equity compensation is quite common amongst start-up companies, especially in developed countries and it is picking up very strongly in these climes. Companies that have recently launched their business don’t have the initial cash flow to cater to all their needs and often rely on equity as a buffer. As I pointed out in my article last week, equity provides a veritable means for start-ups to scale.
Employees are issued different kinds of equity compensation, these may include options, restricted stock, and performance shares; all of these represent a form of ownership of the company for these employees. Oftentimes, equity compensation is accompanied by a below-market salary.
Additionally, the kind of stock employees get is primarily based on the time of joining the company and the role they play. This helps attract high-quality employees at the onset of the company and makes them stay with the company for a defined period thereby allowing the company to get a grip on its trajectory and build a market presence for growth and sustainability without having to worry about loss of pivotal employees.
Equity compensation can also be a viable alternative that helps attract new talent. Even companies that already have robust benefits packages can use equity compensation as an extra incentive to attract the best hands.
*Types of equity compensation for employees
Another question that start-up founders must address is the type of equity compensation to offer to employees bearing in mind the peculiarities of their offerings to the company.
*Employee Stock option (ESO)
The term employee stock option (ESO) refers to a type of equity compensation granted by companies to their employees and executives. Rather than granting shares of stock directly, the company gives derivative options on the stock instead. These options come in the form of regular call options and give the employee the right to buy the company’s stock at a specified price for a finite period. Stock options are a very common form of employee equity compensation. This predetermined price is called the exercise price of the stock options.
Stock options are usually offered with a vesting schedule where the employees are allowed to gain control over the option after working for the company for a specific period. Also, employees are not considered stockholders in the company, which means that they do not have the same rights as that of a shareholder.
Also in Nigeria, the tax implications for employees who are vested with stock options remain quite fluid as the Personal Income Tax Act does not have any provision that addresses the taxation of stock options, some states have however made extant regulations imposing tax obligations in this regard.
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*Performance shares
Another form of employee equity compensation is performance shares. These are incentive-based forms of stock compensation paid to employees particularly C-suite employees if certain benchmarks are met. They only become due when special conditions are met.
Typically, performance periods are over a multi-year period and are usually part of a long-term performance or incentive plan. Employees earn the payout in shares by meeting agreed targets between them and the company.
*Deciding the quantum of distribution
One major challenge many start-up founders have is deciding how much equity to vest and the right employee fit for such offers. This is also the question of giving only equity or creating a mixture of equity and a reduced salary. Addressing these issues is very essential because it will help prevent problems in the future.
While there are no guidelines as to how much equity each kind of employee should get as every business is different, there are some things that you will need to consider. These include:
• The employee’s predicted impact on the success of the company.
• The amount the employee will get in salary and how much lower it is in the prevailing job market.
It is important to do a quiet survey to determine the approximate amount the employee is worth to the company and offer them an amount of equity that is equal to their worth, bearing in mind the company’s profit forecast.
*Conclusion
Equity compensation could be a great employee benefit, especially if you like the idea of becoming a stakeholder in your company. However, employees must keep in mind that there are requirements that must be met the principal of which is staying in the employment of the company for a defined period. This is why is important for both the employer and employee to have a defined expectation at the onset and have the right paperwork in place to solidify the relationship and the benefits and responsibilities that arise from the same.
Omoruyi Edoigiawerie is the Founder and Lead Partner at Edoigiawerie & Company LP, a full-service law firm offering bespoke legal services with a focus on start-ups, established businesses, and upscale private clients in Nigeria. The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances. His firm can be reached by email at hello@uyilaw.com
