Stock options are widely utilized to reward startup employees and are a popular choice for attracting, retaining, and motivating hires. They have become almost synonymous with equity compensation, particularly in early-stage startups where limited cash makes it challenging to offer competitive salaries and bonuses.
However, founders need to be aware of and consider alternative options when designing equity compensation plans. A well-rounded employee equity compensation plan must take into account various alternatives that may better suit your startup’s specific circumstances.
In this article, we’ll discuss three reasons why relying solely on stock options may not be ideal and explore a range of alternatives, including phantom stock and performance awards.
Why stock options aren’t everything
Stock options are both effective and popular but relying solely on them for equity compensation plans will pose significant problems down the road. These include:
Even for startups in Series A, B, C, and beyond, the highly volatile nature of startups means that the value of your startup's stock is extremely unpredictable. Factors that are out of your control, ranging from market conditions to your company's performance to even consumer behaviors, can heavily impact it.
This unpredictability poses challenges for both founders and employees in accurately assessing the concrete financial benefits of stock options.
Relying solely on stock options can result in excessive ownership dilution. You must implement and balance appropriately with alternative, non-equity approaches.
If ignored, potential investors may be deterred from investing. You might even risk losing control over the decision-making process, potentially derailing your startup from its overarching mission.
#3 Legal implications
Stock options aren’t without strings attached. Often, they come with a wide range of legal and tax considerations that employees must be mindful of.
These considerations include compliance with securities laws, taxation upon option exercise, capital gains tax, and even provisions for clawbacks and varying vesting periods, depending on the startup.
Alternative compensation to stock options
Because of the issues discussed above, founders would be wise to consider alternative forms of compensation as part of their employee equity compensation efforts. Potential options include:
Performance awards are a form of compensation given to employees when they complete a startup’s predetermined goals and milestones. These goals can encompass various targets, such as meeting specific KPIs (e.g., sales targets) and achieving financial performance objectives.
While performance awards can involve stock grants, they frequently comprise cash bonuses or a combination of stock and cash bonuses. The value of these varies based on the level of accomplishment. Implementing performance awards is an effective method to incentivize employees to perform at their best.
Stock appreciation rights (SARs)
SARs (Stock Appreciation Rights) is a distinct form of compensation that grants employees the right to receive any increase in your startup's value over a designated period without requiring them to pay an exercise price. In simpler terms, employees are not required to purchase shares.
Instead, when employees decide to exercise their SARs, they receive compensation in the form of cash, rather than equity. This enables them to benefit from the appreciation of your startup without needing to possess ownership stakes.
Restricted stock units (RSUs)
RSUs essentially ensure that employees will receive shares of your startup at a later date. However, they are often accompanied by various restrictions and require a vesting period to be fulfilled before the shares can be accessed and utilized by the employee, such as for selling or transferring.
RSUs do not require employees to purchase stock options and serve as an excellent means to incentivize current employees. They are relatively simple to administer compared to other options. However, it's important to note that RSUs do not entitle employees to receive dividends or voting rights.
Restricted stock awards (RSAs)
Similar to RSUs, RSAs are a type of compensation that comes with several restrictions, including vesting conditions and the inability to freely trade them. However, once an employee accepts the RSA, they technically own the shares right away. Once RSAs are fully vested, the holders gain unrestricted access to the shares.
RSAs are beneficial because they offer immediate ownership instead of a promise of future ownership. They also grant employees benefits like voting rights and are cost-effective since they do not require tapping into a startup's cash reserves.
Phantom stock, as the name suggests, offers employees cash or equity bonuses based on your startup's share performance, resembling synthetic equity units that reflect the market performance.
While similar to SARs, phantom stocks differ in two key ways. First, employees holding phantom stock do not possess legal ownership rights to your startup's shares. Second, when settling phantom stock in cash or equity, it is based on the value at that specific time, whereas SARs calculate the settlement amount based on the difference between market price and grant price upon exercise.
Effective employee equity compensation requires founders to be aware of the range of alternative compensation options available beyond stock options. That said, planning and execution are entirely distinct challenges.
That's why founders should consider using cap table software to streamline time-consuming processes and provide real-time transparency over equity ownership. Tools like these have the potential to support startups of all sizes.
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