In most startup companies, with cash in limited supply and a relatively high risk that the venture will fail, it can be difficult to recruit top talent as employees and advisors. Incentive equity grants provide a solution to this problem, serving as both a substitute for the higher cash compensation that an employee or service provider might receive working for a larger or later-stage venture and/or a means of rewarding the risk associated with early stage ventures.
In order to assure expected tax outcomes and availability of safe harbors under applicable securities regulations, grants of incentive equity are usually established pursuant to an incentive equity plan, which we will discuss below. Additionally, since most startups rely on capital investments to fuel growth, it is important that they understand how incentive equity plans may impact their future capital raising efforts, a topic we will address in a companion post.
Incentive Equity Pool Basics
Incentive equity plans are created by designating a “pool” (a/k/a “incentive equity pool,” “option pool,” “employee stock option pool” or “ESOP”) comprised of a proportion of a corporation’s equity that is specifically allocated for grant to service providers (employees, contractors/advisors) to incentivize their performance and align their interests with the long term interest of the corporation’s founders and its investors in the growth of the corporation’s equity value.
The pool is comprised of shares of common stock, which is usually the same class as is held by the founders and therefore carries the same economic rights. Occasionally, a separate series is designated for the pool which carries limited or no voting rights. Grants from the pool may be made in a number of forms, including direct issuance of shares, but generally, they are made in the form of options to purchase shares of common stock at a price per share equal to the per share value of the common stock of the company as of the date of grant of the stock option.
Establishment of an incentive equity pool must be approved by the corporation’s Board of Directors and stockholders. Once allocated to the pool, the shares are not deemed to be issued; rather, they are merely set aside and available for use as grants of incentive equity.
Although a pool is made up of a specific number of shares, the size of the pool is typically described as a percentage of the corporation’s fully diluted equity. For example, if a corporation has a single series of common stock, of which 1,000,000 shares are issued to the founders and outstanding, and a pool of 250,000 shares of common stock is established, that pool would be described as comprising 20% of the corporation’s fully diluted equity.
In Part 2, we discuss how the incentive equity pool interacts with the pricing and dilutive effect of a startup company’s rounds of priced equity fundraising, as well as a few key considerations for founders as they negotiate the size and structure of the pool with potential investors. If you have questions about incentive equity plans or general issues relating to startup companies, please contact Justin McAnaney at firstname.lastname@example.org.
Justin McAnaney is Partner with Outside GC’s New York-based team. Justin is a seasoned corporate lawyer and business leader with a twenty-year track record of providing meaningful legal and strategic advice to businesses of all types and sizes. He regularly advises clients on both transactional issues and day-to-day business matters throughout the corporate lifecycle, including assisting start-up companies with arrangements between co-founders and structure and fundraising matters.