The startup founder's guide to employee equity compensation

Raising funds to sustain your startup’s mission along with developing and selling your unique idea are certainly pieces of the startup puzzle. That said, hiring and retaining employees is just as important. It is vital to recognize that roughly 65% of failed businesses attribute their downfall to poor employee management. 

Employee happiness is at the core of all compensation plans, equity-based or otherwise, and it’s key to never lose sight of this fact. Happy employees go a long way in building a healthy, productive, and united work environment. They can even spread the good word about your startup to potential hires, all setting you up for success.

To learn more about employee equity compensation and how you can achieve this, read on.

What is employee equity compensation?

Equity compensation is a highly effective tool for startup founders to attract and retain top talent while conserving cash. This is especially crucial for startups in all stages of growth, whether they're in the seed stage or Series A, B, or C, as cash is often limited and required to be used in other areas such as fundraising.

There are various types of equity compensation, with the most common being the following:

Incentive stock options (ISOs)

The most common type that offer employees the right to purchase shares of a startup. They may include discounts and/or tax benefits but are often subject to regulations and specific requirements, such as vesting schedules and clawback provisions.

Non-qualified stock options (NSOs)

While similar to ISOs and commonly used, NSOs differ in that they do not come with tax advantages and can be offered to third parties such as external counsel and vendors.

Restricted stock awards (RSAs)

RSAs grant employees with shares; however, these are often subject to specified requirements, usually a vesting period, which must be fulfilled before employees’ rights to the shares are unrestricted.

Restricted stock units (RSUs)

RSUs are akin to RSAs though they do not provide employees with immediate ownership of the shares and are not transferable until pre-defined conditions are met (e.g. a vesting period).

Performance shares

Performance shares are a powerful tool used to incentivize employees to achieve specific milestones and goals, effectively aligning their productivity with the success of the startup.

Employee Stock Ownership Plan (ESOP)

ESOPs are benefit plans that confer tax advantages to employees and the startup which allows employees to obtain shares of your startup.

Employee Stock Purchase Plan (ESPP)

ESPPs give employees the right, but not the obligation, to purchase shares of your startup at a discounted rate, subject to pre-specified conditions.

Why keeping employees happy is important

Utilizing compensation as a tool is crucial because your employees form the backbone of your startup's operations, ultimately determining whether your startup succeeds or fails. Nonetheless, at the heart of all equity compensation plans is employee happiness. Founders must always remember this because:

Employees form the backbone of a startup’s culture

It doesn't matter how many goals you set or how many hours you spend fine-tuning your startup's code of conduct because, at the end of the day, it is entirely up to your employees whether or not they choose to live and embody your vision. 

Employees often outnumber founders and form the backbone of any startup. Unless they feel valued, heard, and appreciated, they may not be as committed to helping establish a positive culture.

Employees can boost a startup’s reputation

Happy (and unhappy) employees are often the most vocal, highlighting the importance of ensuring their happiness. They can be an ambassadors for your startup, spreading positive sentiments about your company. It is always beneficial to have favorable things said about your startup than otherwise. 

From positive word-of-mouth referrals to glowing online reviews, content and satisfied employees play a crucial role in enhancing your startup's reputation. Their positive experiences and endorsements contribute significantly to improving your startup's standing within the industry and among the general public, ultimately bolstering your credibility and fostering trust.

Employees are more productive

Good equity compensation plans mean that employees are properly compensated, resulting in increased contentment. This often leads to a more motivated, productive, and engaged workforce.

This goes a long way in minimizing any bouts of discontentment and complaints regarding equity compensation. If mishandled, such issues can foster an environment of negativity, inequality, and distrust within your startup which will ultimately derail your startup's daily operations and jeopardize your mission.

Employees form the backbone of a startup’s culture

It doesn’t matter how many goals you set or how many hours you spend fine-tuning your startup’s code of conduct because, at the end of the day, it is entirely up to your employees whether or not they choose to live and embody your vision.

Employees often outnumber founders and form the backbone of any startup. Unless they feel valued, heard, and appreciated, they may not be as committed to helping establish a positive culture.

Employees can boost a startup’s reputation

Happy (and unhappy) employees are often the most vocal, highlighting the importance of ensuring their happiness. They can be an ambassadors for your startup, spreading positive sentiments about your company. It is always beneficial to have favorable things said about your startup than otherwise.

From positive word-of-mouth referrals to glowing online reviews, content and satisfied employees play a crucial role in enhancing your startup’s reputation. Their positive experiences and endorsements contribute significantly to improving your startup’s standing within the industry and among the general public, ultimately bolstering your credibility and fostering trust.

Employees are more productive)

Good equity compensation plans mean that employees are properly compensated, resulting in increased contentment. This often leads to a more motivated, productive, and engaged workforce.

This goes a long way in minimizing any bouts of discontentment and complaints regarding equity compensation. If mishandled, such issues can foster an environment of negativity, inequality, and distrust within your startup which will ultimately derail your startup’s daily operations and jeopardize your mission.

3 benefits of good employee equity compensation

Saving cash is just the beginning when it comes to the comprehensive range of benefits offered by employee equity compensation. By compensating employees with equity, founders not only conserve cash, which can be used for other purposes but also offers employees a stake in the startup's future profits, aligning their efforts with the success of the company.

This is beneficial for startups for several reasons:

1. It fosters a sense of collective ownership

When you compensate employees with equity, you align the interests of your company with the interests of your employees. 

This goes a long way in forging a sense of collective ownership, whereby each employee's efforts directly contribute to their own success and the success of the startup. It encourages employees to think and act like founders, promoting accountability and teamwork, and overall creating a more cohesive work environment.

2. It attracts investors

Stability and a trajectory for long-term success are key factors potential investors tend to look for when making a decision on whether or not to invest in a startup. 

Accordingly, when investors see that your employees are motivated, productive, and aligned with your startup's objectives, it significantly strengthens confidence and trust among investors. This, in turn, makes them – both existing and potential investors – more willing to invest time and capital into your startup.

3. It retains human capital 

Properly implemented equity compensation practices significantly contribute to ensuring employees feel appropriately rewarded and valued. This not only incentivizes performance but also aids in talent retention, minimizing turnover and attrition to competitors. 

Hiring new employees and the associated onboarding and re-training processes are cost-intensive, making employee satisfaction and retention crucial for redirecting resources to more productive areas like fundraising.

Employee equity compensation best practices

Creating an employee equity compensation plan may appear straightforward, as it involves granting equity. However, designing an effective plan requires careful consideration.

Even seemingly minor choices can have significant consequences down the line, potentially leading to far-reaching impacts. That said, to avoid issues like this, consider the following best practices:

Fully utilize vesting and cliffs

Vesting and cliffs are effective tools for fostering alignment within a startup, uniting employee interests with the overall goals of the company. When implemented correctly, vesting ensures that employees receive appropriate rewards for their loyalty and contributions over time. 

Similarly, cliffs establish important milestones, such as performance targets, that employees understand they must achieve and work towards to unlock the benefits of their equity compensation plans.

Use cap table software

Cap table software, such as LTSE Equity, can be leveraged for both planning and executing employee equity compensation plans. It offers a range of functionalities, including scenario modeling to visualize the impact of option pools, promoting transparency by providing visibility into equity holdings, facilitating the issuance of options, and managing ESOPs. 

By using cap table software, startups can ensure alignment and make informed decisions, fostering efficient and effective management of employee equity compensation as a whole.

Implement ESOPs and ESPPs

ESOPs and ESPPs offer numerous advantages when implemented properly. ESOPs can attract and retain top talent by providing long-term incentives through an ownership interest in the startup, fostering a sense of commitment and alignment. 

On the other hand, ESPPs allow employees to purchase shares at a discounted rate, offering a more immediate way to promote alignment and employee participation in the startup's success.

Consult external advice

Regardless of how well you know your product, team, or mission, there’s no practical way you’ll be able to cover all bases when compared to an expert in equity compensation, such as accountants, lawyers, and more.

Experts can provide a wealth of knowledge built from a career's worth of experience, along with valuable tips, guiding you through regulatory challenges, steering you away from pitfalls, and ultimately helping you make the best possible decisions when designing your equity compensation package.

Fully utilize vesting and cliffs

Vesting and cliffs are effective tools for fostering alignment within a startup, uniting employee interests with the overall goals of the company. When implemented correctly, vesting ensures that employees receive appropriate rewards for their loyalty and contributions over time.

Similarly, cliffs establish important milestones, such as performance targets, that employees understand they must achieve and work towards to unlock the benefits of their equity compensation plans.

Use cap table software

Cap table software, such as LTSE Equity, can be leveraged for both planning and executing employee equity compensation plans. It offers a range of functionalities, including scenario modeling to visualize the impact of option pools, promoting transparency by providing visibility into equity holdings, facilitating the issuance of options, and managing ESOPs.

By using cap table software, startups can ensure alignment and make informed decisions, fostering efficient and effective management of employee equity compensation as a whole.

Implement ESOPs and ESPPs

ESOPs and ESPPs offer numerous advantages when implemented properly. ESOPs can attract and retain top talent by providing long-term incentives through an ownership interest in the startup, fostering a sense of commitment and alignment.

On the other hand, ESPPs allow employees to purchase shares at a discounted rate, offering a more immediate way to promote alignment and employee participation in the startup’s success.

Consult external advice

Regardless of how well you know your product, team, or mission, there’s no practical way you’ll be able to cover all bases when compared to an expert in equity compensation, such as accountants, lawyers, and more.

Experts can provide a wealth of knowledge built from a career’s worth of experience, along with valuable tips, guiding you through regulatory challenges, steering you away from pitfalls, and ultimately helping you make the best possible decisions when designing your equity compensation package.

3 key questions to ask yourself about your employee equity compensation package

Designing and implementing your startup's employee equity compensation package can be a tricky process, given the range of factors that have to be considered. Nevertheless, to help guide you through the process, you should ask yourself the following questions:

1. Have I studied the market and my competitors? 

Understanding the market and what your competitors are offering to employees is important for benchmarking your equity compensation package and ensuring your startup remains competitive. Failing to do so can result in the loss of talented employees, both existing and potential, who may decide to head towards greener pastures.

2. Have I carefully specified all relevant terms of your plan? 

Clearly specifying all relevant terms of your plan is crucial for avoiding misunderstandings and conflicts down the line. By clearly defining vesting schedules, exercise periods, and any other important provisions such as the number of shares to be used, you create transparency, trust, and a sense of fairness among your employees, ensuring everyone understands the terms of their equity grants.

3. Am I constantly updating the plan? 

Employee equity compensation plans are not static or set in stone. As your startup grows and onboards new employees, needs, requirements, and expectations will change, requiring you to adapt accordingly. Don't forget to frequently review your plan, ensuring you quickly identify and rectify any potential areas of improvement to keep your plan as competitive and attractive as possible.

Alternatives to note

Despite the utility of equity compensation, it’s important to remember that it is not the be-all-end-all for compensation. There are many non-equity-based alternatives out there that founders must be aware of and consider, balancing them alongside equity-based compensation. Such examples include:

Base salaries

• The bread and butter of any compensation package, base salaries offer a stable stream of income for employees.
• Equity compensation is certainly important but competitive base salaries are often prioritized by many potential hires who may be risk-averse.

Cash bonuses

• Short-term, tangible incentives that reward employees for exceptional performance with additional cash.
• Like equity, bonuses strongly make employees feel appreciated and valued in exchange for their commitment to the startup.

Commissions

• Commissions are a solid way to tie excellent performance with rewards.
• However, commissions are generally only applicable for sales and revenue-generating roles.

Profit sharing

• Distributes a portion of your startup’s profits to employees.
• Like equity compensation, it can help align the interests of your employees with that of the startup, but in place of equity, profit is given away.

Additional benefits

• Cash and equity are not the only ways to foster a sense of loyalty and alignment with your employees.
• Additional work benefits such as flexible work arrangements, unlimited paid time off, and even wellness programs all go a long way in promoting employee happiness.

Manage employee equity compensation with LTSE Equity

No two employee equity compensation plans will ever be the same. Each must be designed according to a startup's unique circumstances, goals, and mission. Accordingly, it's crucial for founders to remain light on their feet, constantly adapting their plans as situations come and go.

However, amidst these variations, one constant factor remains: the importance of cap tables. Cap tables provide clear, accurate records of equity ownership at any given time, making them invaluable in the context of equity compensation.

Solutions like LTSE Equity offer not only cap table management but also a range of additional relevant features, including scenario modeling, compliance support, and comprehensive tracking of employee equity. Discover the full capabilities of our platform by trying our fully interactive demo.