There is a significant difference between promising equity and issuing equity to a startup employee. This article will explain the distinction and why it is important to both the company and employee.
Promising equity means committing to provide equity in the future. Issuing equity means actually transferring ownership of equity to the employee.
The promise is simple. Depending on how it is made and documented, the commitment may or may not be legally binding. Promising equity is straightforward. For example, a founder could say to a potential employee, “I promise you a 1% equity stake in the company.”
The issuance is much more complex. To issue equity, several questions need to be answered, including but not limited to:
- What is meant by “equity”? Is it a stock grant, stock option or restricted stock unit?
- Common or preferred shares?
- Does it vest?
- If so, what is the schedule?
- Will it accelerate upon acquisition? If so, is it a single or double trigger? Is acceleration triggered if the employee leaves for a good reason?
- What is the fair market value?
- What are the restrictions on these shares?
- What about the 83(b) election?
- What does 1% mean? Is it 1% of authorized shares? Issued and outstanding? Fully diluted?
- Has the board approved the issuance? If not, when will they?
Once all of these questions are answered, they are documented in the equity grant docs. Equity issuance triggers security laws that require compliance with federal and state regulations. Failure to comply can result in fines or other penalties.
Startups should consult with legal professionals when making decisions about promising or issuing equity to ensure they comply with applicable laws and regulations. If you are looking for legal counsel, feel free to reach out to us here.
When Equity Is Promised
Equity is promised in several ways:
- Verbally: During the recruitment process, a company and potential employee may discuss and negotiate the amount of equity they believe is fair.
- Offer letter: Once an official offer has been made to a potential employee, the offer letter will contain specifics of the equity award, such as the number of shares and the vesting schedule.
- Independent contractor agreement: If the company is offering equity to a contractor, the independent contractor agreement will contain specifics of the equity award, such as the number of shares and the vesting schedule.
- Advisor agreement: Startups frequently issue equity to advisors. The advisor agreement will detail specifics of the equity award, such as the number of shares and the vesting schedule.
Even though the last three items on this list are legally binding contracts, they still only serve as a promise of equity. They do not issue equity.
When Equity Is Issued
Equity is only legally issued upon execution of one of the following agreements:
- Restricted stock grant (sometimes called a restricted stock award or RSA)
- Stock option grant
- Restricted stock unit grant
Until one of these agreements has been executed, equity has not been issued.
Why the Distinction Between Promising and Issuing Equity Matters
Understanding the difference between an equity promise and an equity issuance is crucial for both the employee and the company.
For the employee, they will not have any ownership interest in the company until the equity issuance is fully executed, even if the company has promised them equity.
For the company, there are two reasons why this distinction matters. First, promising equity to an employee and not following through on the issuance can create significant bad will. Second, having an accurate understanding of the founder’s, employee’s and investor’s percentage of ownership in the company requires a clean and updated cap table. Without it, the company can accidentally issue more employee equity than it has, which can have negative repercussions.
Lastly, an equity promise, even if it is written in a contract, is often less precise than an equity issuance. For example, an equity award may be agreed upon and equals a 1% stake in the startup. The employee may assume that means 1% of authorized shares, but the company may assume that means 1% of fully diluted shares. This can result in a significant difference. This is why it is recommended to discuss the number of shares rather than percentages in both equity promises and awards.
Mind the Gap
Startups may take longer to process an equity award than an equity promise because the board needs to approve equity issuances. This can result in a gap of several months between the equity promise and award. To simplify the administrative process, equity issuances are often batched and approved by the board on a quarterly basis. However, if an employee is hired at the beginning of the quarter and the company is on a quarterly issuance cadence, the gap between the promise and issuance could be nearly three months.
To avoid misunderstandings, companies should clearly communicate the timing of equity issuances and stick to the schedule. Failure to do so may create unnecessary tension between the company and its employees.
Equity can be a powerful tool for shaping company culture and boosting employee morale. Startups should use this tool strategically, while considering its potential impact on employee trust, satisfaction and motivation.