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Attention to equity and options in early business

This message is longer than usual. For those who are trading equity allowances, it covers some of the most complex issues to deal with in the process. I could not reduce it to a lot less words … Dave

Here is the warning: The execution of partnership equity awards and a good incentive program using equity is often poorly managed, damaging the corporeal capitalization structure and even affecting the outcome of subsequent investments in the company.

Here is an example: First of all, a brand new company is often formed by the efforts of several "partners", each with expertise valued by others. Equity is distributed among the founders and the company started. Although this idea does not address this point of departure, it should be noted in passing that things always change over time and that former founding contributors can become a brake on a business or lose interest if the company does not succeed quickly.

To protect against this, there must be a document in place from the beginning that clearly states the expectation of each founder as to the contribution of time and resources to the company. The document should also contain clear buy-sell clauses, forcing the sale of shares to the company's treasury, then to other founders in proportion to their holdings, and then interest-free, to investors external. It should contain a mandatory sale clause in case of separation from a founder, so that a significant owner who is passive in the business can not easily vote against the measures adopted by the company. other active founders.

And then there are options: Stock options or fictitious actions are the tools of early-stage companies used to attract great talent when it is not necessary. there is not enough money to pay the market rates. There are rules. You must first create a stock option plan using your lawyer, which must be registered in many states as a security offer. (The registration fee is well under $ 100, so that's not a problem.) Options are usually better with "C" companies, but the option grant is for LLC companies or "S" is not a real problem.

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Most early-stage companies make the mistake of making options concessions to new employees at all levels who are too aggressive and distort the company's capital structure in a measure that harms future professional investments. Let me try to advance some rules of thumb to guide you here. An option plan should exclude approximately 15% of "fully diluted" shares. If there are 85,000 shares issued to the founders, then a plan with 15,000 shares in a pool reserved for future recruitments is appropriate, making the shares fully diluted to 100,000. The board must approve the plan, including including this number, and the shareholders must also approve the plan. Each grant to new or existing employees must be approved by the board prior to issuance.

How about the price per share? The price per share for the grant of options is also an important factor. Rule 409a of the IRS specifically provides for an assessment of the value of the shares of the company at less than one year of any grant of options, although there is an exclusion for the Early stage companies in which expert members of the organization can make such an assessment. they qualify under the exemption. There is only one category of shares, the same as the founders, and the valuation of the single class of shares yields, let's say 2 $ 00 per share, so options should be valued at that amount. In other words, you can not create deals below "market rates". If you have a preferred stock class with special protections, this stock class will be valued at a price higher than ordinary shares at a lower price per share than preferred investors may have paid. This is important because high quality candidates should be brought to consider coming on board at below-market wages using the tool "cheap" options, at an adequate price.

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How many options are suitable for a grant? What percentage of the total shares of the company should be reserved for what specific job titles? Encouraging a new CEO to ride usually means creating an option package of 5 to 8% stock options. This grant size would take a lot or most of the pool of options. A vice president, or CxO candidate, is usually offered between 1% and 1.5%. Management level employees are generally granted ½%. In general, all other subsidies are much lower, allowing most companies to have a 15% pool for a long time.

We will cover board members and advisory board members at a later date.

The options are usually earned over time, which we call acquisition. If an allotment of 10,000 shares is made on January 1, there is usually a vesting period of four years during which the employee is entitled to exercise 1/48 th (19459011) shares every month.Many plans also provide for a "cliff" of one year during which an employee who is separated from the company before a year is unable to even perform the actions that would have been acquired at that time.

Are there any other important considerations? There is an important consideration that will become a problem with sophisticated candidates for VP and more. We refer to these "trigger" provisions, in which selected options traded for a select group of senior executives, are fully vested 100% in any change of control. This provision allows these people to take advantage of the acquisition by allowing them to fully exercise their options at the time of the sale. The downside of this is that the buyer may not want to so enrich those managers that they may not be willing to come on board the buyer's organization, even if the Existing options are replaced by options from the acquiring company.

If all of this sounds a little overwhelming, we just scratch the surface of option plans and incentive pay. It's an area of ​​expertise that a CEO needs to learn quickly and manage with care with the help of the corporate and board lawyer. d & # 39; administration.