Guide to Equity Incentive Plan for Businesses & Startups
Naturally, a new business is tight on capital in its early phases. However, funding for new businesses has become far more complex because of the pandemic, followed by the funding slowdown in 2022. How can an entrepreneur acquire the necessary workforce to propel their company forward? The answer is to implement an equity-based incentive plan for employees.
What is an equity incentive plan?
In startups, equity incentives compensate employees with company shares that may be in the form of stocks, stock grants, warrants, and bonds. Equity is commonly combined with base pay or fixed salary in cash. The cash component is paid as a monthly salary, but equity vests over 3 to 6 years.
Why is an equity-based incentive plan important for your business?
In startup companies, equity incentives come from the option pool or ESOP pool which is generated when founder shares are diluted. This is because the company stands to gain significantly from it.
Here are some benefits the company gets from an equity-based incentive plan.
1. Boosts pay without reducing cash flow.
Wages are an ongoing cost to the company. In the context of a new business with uncertain cash flow, reducing the pressure of a monthly cash-based wage system by providing employee equity incentives is beneficial. This helps the company’s finances remain flexible while also contributing to the overall profitability of the business.
In short, equity incentives, which are non-cash benefits, are advantageous to businesses because they enable them to increase the value of the overall pay package without negatively impacting their short-term cash flow.
2. Attracting and retaining top talent
Startups face intense competition. Equity incentives can be an effective tool for companies to recruit and retain top people by raising the overall possibility of financial benefit and showing a willingness to engage in a long-term relationship. Equity incentives also increase an employee’s productivity and engagement and inculcate a feeling of being valuable to the organization. Not only does a well-designed equity incentive plan attract the most talented individuals in the sector, but it also keeps those individuals motivated to align themselves with the company’s goals and continue investing in its growth.
3. Minimizing employee turnover
When starting a new business, it’s common practice to grant equity incentives, but only after meeting specific requirements. In layman’s terms, vesting schedules are essentially a timeline that details the path to ownership of the company’s stock. The distribution of stock ownership takes place over a one to the six-year period called the vesting period. Employees must maintain their employment with the company to get all the benefits.
Additionally, the contributions made by employees directly influence the pricing of the company’s shares. As a result, equity proves to be an effective strategy for retaining employees since it enables those employees to perceive the value that their hard work creates directly.
4. The long-term success of the company
Compared to other forms of compensation, equity incentives offer recipients a distinct benefit in the form of a vested interest in the sustained prosperity of the company for which they work. Equity incentives work to achieve this alignment by bringing the aims of the recipient in line with those of the company’s shareholders, directors, and management.
Non-cash payment is known as an “equity grant.” This type of payment is also referred to as equity compensation. In essence, the recipient will be awarded ownership of something.
Many businesses continue their hunt for innovative approaches that do not include using monetary compensation to encourage and reward their personnel. Some businesses react to this difficulty by providing their workers with equity awards or shares to maintain their satisfaction. Even though many businesses already have a plan for a certain number of their employees, those businesses that do not already have such a plan are looking into putting one in place.
Types of equity incentives
Explore the different types of equity incentive plans and choose the right fit for your business.
1. Restricted stock, restricted stock units, and performance shares
Stock or stock units with specific constraints or goals are one sort of equity incentive pay to be used in the future. They consist of restricted stock, restricted stock units (RSUs), and performance shares.
When you are granted restricted stock, it is a pure grant of business stock, but an employee doesn’t get to keep it until all of the limitations have expired. When vesting, you will get the total market value of your company’s stock, and RSUs can be redeemed for cash rather than stock.
A performance share or RSU grant vests only if a performance goal is met by the company, the individual, or both. For example, the minimum number of years an employee has to stay or an investment a company may achieve in the future. In the same way, as a cash payment would, restricted shares of vested RSUs often result in ordinary income.
However, once shares have been vested, any additional appreciation is taxed as long-term capital gains and is therefore subject to a higher rate of tax. As the grant price is zero, and any value over that is compensation to the owner, grants of restricted shares include downside protection and upside protection.
Employee stock options offered by organizations to employees give their workforce the right, but not the obligation, to buy or sell a stock at an agreed-upon price and date. After a certain time frame (when the vesting period is over), employees can buy a set number of company shares at a set price i.e., the exercise price. Employees must oblige to all the conditions set by the organization for the vesting period to exercise stock options. The company facilitates a buyback program once the vesting period is over, where employees can encash their ESOPs and create wealth.
3. SARs/ Phantom Stocks
Phantom Stocks or Shadow Stocks are an employee benefit plan with certain benefits offered to mostly senior company employees without ownership of shares. Even if they’re mock stocks, phantom stocks follow the price movement of a company’s actual stock, which may result in profits during payouts. There are two types of Phantom Stocks – Appreciation Only plans include only the payout value when the company stock price increases over a certain period. However, Full Value plans pay the appreciation with the underlying stock. Phantom stocks may be mock, but they can still pay dividends and undergo price upgrades.
How trica equity’s tools helped Thoucentric strengthen the relationship with its employees
Thoucentric’s capital generation journey was quite different from its peers. The company did not go through the private equity or venture capital route. Profits were capitalized, and the company’s Retained Earnings were plowed back into the business. This led to Thoucentric’s capital generation. As the working capital needs grew, a round of raising equity through friends and family occurred. Once the Thoucentric Lab was set up, the company issued debentures to people within its known circles. The impact of this capital structure over time is neatly captured by trica equity’s Cap Table tool. This is an excellent example of how technology facilitates transparency and establishes trust.
Equity incentive compensation can be especially beneficial to early-stage startups that may not have a cash surplus to compensate their talent and retain them. Moreover, for startups to attract potential investors, equity incentive plans serve as a reserve to attract and retain a quality workforce. Drafting an equity incentive plan for your workforce? Check out how trica equity can help you.