It’s nearly every small-business owner’s nightmare and dream: to provide key employees with equity.
The idea of diluting your ownership may feel somewhat like giving away your firstborn. But when your company’s future prospects look better than its current bank balance, offering a piece of the business and/or a chance to obtain warrants (often called “stock options”) is an attractive way to reward and incentivize people without spending a penny today.
If you’re thinking about giving equity to your staff, here are some factors to consider before you take the plunge.
Types of Equity
As you probably know, equity (ownership) in an incorporated small business generally gets broken down into:
- Common stock – the most common type of equity, each share confers ownership of a small portion of the business
- Preferred stock – also confers ownership, but receives its dividends before common stock
- Issuing shares – common stock given for free to key people, usually when the company is first starting
- Warrants (often called “stock options”) – do not immediately confer ownership, but confer the right to buy shares of the company’s stock, usually during a specified time period (often beginning several years in the future) at a specified price (often a share’s market price at the time the warrants are granted)
Your company can be owned through shares of stock without having those shares traded on the public stock markets. Regardless, transferring any of these financial instruments is a highly complex, thoroughly regulated activity. Don’t try it without an expert lawyer to advise you.
One attractive attribute about warrants (stock options) is that they can increase in value without costing a dime.
For example, if you give warrants to buy 1,000 shares of your company’s stock at $10, and those shares reach $15 in value, each of those warrants is intrinsically worth $5 — free money to whoever holds those warrants.
How Much to Offer
There’s no simple guide to offering warrants/stock options, but there are some basic parameters. Advocates of offering equity (in the form of warrants/stock options) suggest that an executive or a key first-stage hire can easily deserve up to 2 percent of the company after all options are exercised.
In deciding how much to offer, bear in mind that the financial incentive of each stock option can be huge. If your company does well and the stock value soars, early-stage option owners can easily see the underlying share price climb well above their options’ exercise price.
And of course, there’s no upper limit to your company’s stock price.
What’s more, options can gain intrinsic value without being exercised, and the employee does not pay tax on that value until he or she actually sells the options or the stock purchased with them. As a result, your employee feels rewarded, and his or her net worth climbs, without incurring a tax bill.
Even better, if employees hold the stock for a full year or longer before selling, they pay tax on the profits not as income but at the lower capital-gains rate.
Again, there are no cut-and-dried standards, but most small companies require an employee to remain on the job for a least a year before vesting (ownership) in his or her stock options begins to ramp up. You can create the warrants so that, after the initial wait, the employee vests in them a little at a time — perhaps a few percentage points each month, quarter, or year.
Generally, you’ll want your employees to become fully vested in the warrants after four or five years.
Although that may seem like a long time, the waiting period helps you to retain key employees, and because the warrants lock in the share price at the time they are granted, a longer vesting period actually gives the share price more time to increase.
Stock options have little reward or motivational value for employees who don’t understand what they are or how they work. But when they do understand them as a variation on “good wages,” they rank very high as a motivator. That’s why it’s good business to make sure your employees understand the warrants you are offering.
Employees who receive this kind of equity opportunity are likely to feel a need to work harder toward the success of the company. And, as partial owners of the business, they stand to gain both financial and emotional rewards.
In addition, this kind of equity offer can provide you with a broader basis for judging your company’s financial outlook: If potential recruits are unmotivated by your offer of stock options, it’s fair to wonder what problems or potential pitfalls they foresee — issues that you as a business owner may be overlooking.