Equity Incentives for Employees: Explained

Commercial LawHuman ResourcesEmployment Law
Written By James Taylor
Equity Incentives for Employees: Explained

One of the most common challenges that early-stage businesses face is how best to recruit and incentivize talent at a time when funds are tight.  A start-up, even if recently funded, can struggle to entice senior-level staff who might command six-figure salaries at bigger, more established firms.

And while the excitement of embarking on a new adventure might be enough to tempt some, for many, leaving a comfortable job for the uncertain world of a start-up is too much of a risk.

One tool that founders reach for when trying to supplement salary is the offer of equity in the business.  Which makes sense.  If you can’t quite pay market-rate, then the offer of shares in a company which might be worth millions down the road isn’t a bad proposition.  It’s a gamble for the employee, but one with a hefty upside if it pays off.

But, while it may seem like the obvious solution, it is vital that a founder considers (a) whether it is indeed the most appropriate approach; and (b) if so, how best to actually do it.

According to James Kearns, Dragon Argent’s Head of Legal, there are a few key things to consider:

1.  Are shares actually worth having?

Put broadly, if you own shares in a company, you own a bundle of rights relating to that company – principally the right to vote, the right to dividends, and the right to receive the proceeds on a liquidation or, more optimistically, on the sale of the company.

So, if you own – say – 5% of the shares in a company which is not profitable and has no intention of an exit anytime soon, what use are those shares exactly?  You’ll get no dividends, no sale proceeds, and you’ll have no influence on the running of the company.  Still sound tempting?

Conversely, let’s say you have 5% of a company which has a clear 5-year plan to scale up and sell out.  OK, so you’ll still have very little influence, and you’ll probably never see any dividends, but – if all goes to plan – you’ll have a good chance of a chunky pay-out on exit.

Or, consider owning 5% of a company which may not have any exit strategy, but becomes highly profitable and distributes generous dividends.

The point here is that equity is only worth having if the circumstances and the plans of the business give that equity value.

2. Is equity incentivising for everyone?

We’ve already painted a picture of how dishing out equity with the promise of an exit could be a real incentive for some employees.  However, this isn’t always the case.

Some employees, perhaps those earlier in their career, may see a 5-year exit plan as too distant or intangible.  They may not want to commit themselves to one company for that period, or they may simply have other priorities.

Equity should always be just one option among many when considering how to best incentivize or recruit staff.  A performance-based commission, an annual bonus, flexible working, an extra couple of days’ holiday – these may be sufficient to keep staff happy without having to add another name to the cap table.

3. Is the employee a long-term fit?

A business with an ambitious growth plan can often find that an employee who is a perfect fit for the first year or so of a company’s journey soon finds themselves out of their depth as the business scales and becomes more sophisticated.  As headcount increases, those initial employees who thrived when working in a small, informal team might now be expected to take on a broader, more formal managerial role for which they are simply not suited.

Equity is usually a tool to incentivize employees to stay for the long haul.  But sometimes it’s not in the best interests of the business for certain recruits to hang around too long.

4. How does a company give its staff equity?

So far, we have talked rather broadly about staff having, or being given equity.  But what does the process usually look like in reality?  There are a couple of mechanisms to mention:

4.1. Share issue on incorporation (with a “clawback”)

It can mean that certain founding members of the team are simply issued with shares on or shortly after the incorporation of the company.  They may not be “founders” per se, but they are there from the start.

It is in these circumstances that businesses should be most cautious.  Shares – once issued – are not easy to take away.  So, if an employee simply decides to walk away after 6 months in the job, the default position is that they take their shares with them.  Here, companies need to have in place an agreement whereby shares can be clawed back from them. 

4.2. EMI options

Once a business has started trading and perhaps taken on some investment, it is not quite so straightforward to simply issue staff with shares. Quite aside from whether a company’s investors would approve, those shares will now have a value, presenting the employee with a potential income tax liability on issue.

One common approach to get round this problem is to grant an employee an option over shares, often under the auspices of the Enterprise Management Incentives (EMI) scheme, which offers generous tax benefits.

Granting options under an EMI scheme means that a company does not actually issue shares until the options are exercised, which keeps staff off the cap table for the time being.  It also ensures that employees will only ever be issued with shares in specific circumstances (e.g. on exit, or after a minimum period of commitment to the company, or on the satisfaction of certain performance targets). In other words, it makes sure that the employee has done enough to earn the equity.

Get an EMI share option scheme advice from our experts today by scheduling a discovery call.

4.3. Growth shares

Some companies are not eligible to grant EMI options, and some employees are not eligible to receive them.

An alternative option is to issue employees with “growth shares”.

Let’s say that a company is worth £10m.  If that company were to issue a new employee with 5% of the shares of the company, then not only would that employee face the tax liability referred to above, but – from the company’s perspective – they would also be unfairly enjoying a share of the value of the business that they had not done anything to help create.

Growth shares solve both those issues.  The rights attached to the growth shares would be structured such that if the company were sold, then this employee would not share in any of the sales proceeds up to the first £10m; he would only enjoy a share of any proceeds above that amount.   

This is fairer to those who got the company to its £10m valuation.  It also means that the growth shares – at the time of issue – are essentially worthless, thereby avoiding the income tax hit for the new employee.

In Summary

This article represents the briefest of looks at some of the considerations of issuing key employees with equity in a business.  As mentioned, this is not something that should be done lightly. All parties need to consider if it is the right tool for them as it can be a fairly timely and costly process. Is it meaningful and motivating for the employee?  Is it a good long term solution for the business?

Even if these fundamental questions are answered satisfactorily, there are then a number of avenues an employer can go down in actually issuing the shares. At minimum, each avenue will require the drafting of appropriate legal documentation and certainly granting EMI options or growth shares will require a valuation of the business, which is on its own, will feel quite an expensive endeavor for a startup.

However, if the above is navigated successfully then employers will have secured key employees in a long-term arrangement and will have incentivized them to build the business, giving them a sense of ownership in the process.

If you’d like to discuss this further, schedule a discovery call with the Dragon Argent and we’d be happy to give you some bespoke guidance.

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James Taylor https://www.dragonargent.com/james-taylor
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