Understanding Startup Equity Vesting Schedules and Share Options 

Understanding equity can be daunting for new entrepreneurs and employees alike. Equity, vesting schedules, and share options are fundamental concepts that can significantly impact the financial future of a startup and its team members.  

How do you ensure fair distribution of ownership? What are the best practices for setting up vesting schedules and share options? In this blog, we'll demystify these terms and provide you with a clear understanding of how they work. 

Background Information 

Startup equity refers to the ownership stake that founders, employees, and investors have in a company. It’s a crucial element in attracting talent and securing investment. Vesting schedules and share options are tools used to manage this equity.  

A vesting schedule shows when and how employees receive equity or share options. It helps keep employees at the company until they earn their shares. Share options allow employees to purchase shares at a discounted price after a specific period of time. 

Vesting Schedules 

A vesting schedule is a timeline over which employees earn their equity. The most common type is the "four-year vesting schedule with a one-year cliff." This means that employees must work for the company for at least one year before earning any equity (the cliff), after which they gradually earn the rest over the next three years. This approach encourages long-term commitment and ensures that the company retains its valuable talent. 

Types of Vesting Schedules 

• Time-Based Vesting: Employees earn equity based on the length of their employment. 
  

• Milestone-Based Vesting: Equity is earned when specific project milestones or company goals are achieved. 
  

• Hybrid Vesting: A combination of time-based and milestone-based vesting. 
  

Share Options 

Share options are a type of equity compensation that gives employees the right to buy a certain number of shares at a predetermined price, known as the exercise or strike price. These options become valuable if the company’s share price increases above the strike price. 

Types of Share Options 

• Incentive Share Options (ISOs): Typically offered to employees and come with tax benefits. 
  

• Non-Qualified Share Options (NSOs): Can be offered to employees, directors, contractors, and others but do not have special tax treatment. 
  

• Restricted Share Units (RSUs): Company shares given to employees as part of compensation but are subject to vesting criteria. 
  

Equity Distribution Strategies 

Founder Equity 

Founders usually hold a significant portion of the equity, which reflects their initial investment and risk in starting the company. However, it’s essential to balance founder equity with future needs for attracting talent and investors. 

• Initial Allocation: Founders should consider an initial allocation that reflects their contributions and future roles. It's common to allocate between 50-80% of total equity to founders at the outset. 
  

• Future Dilution: Founders must be prepared for dilution of their ownership as the company raises capital. Keeping a reserve of unissued shares for future employees and investors is crucial. 
  

• Equity Splits: Discussions and agreements about equity splits among founders should be transparent and documented to avoid future conflicts. 
  

Employee Equity 

Allocating equity to employees is a powerful tool for attracting and retaining talent. This can be done through share options, RSUs, or direct share grants. 

• Equity Pool: Establishing an employee equity pool, usually ranging from 10-20% of the total equity, ensures there is enough equity to incentivise current and future employees. 
  

• Employee Stock Ownership Plans (ESOPs): ESOPs are a type of employee benefit plan that gives workers ownership interest in the company. Businesses use them to align employee interests with shareholder interests and as a corporate finance strategy. ESOPs can enhance company performance, increase employee satisfaction, and help attract and retain talent. 
  

• Performance-Based Grants: Equity can be tied to individual performance and company milestones, ensuring that employees are rewarded for their contributions to the company's success. 
  

• Communication: Clear communication about the value of equity and how it works is essential to maximise its motivational impact. 
  

Investor Equity 

Investors typically receive equity in exchange for capital. The amount depends on the stage of investment, the amount invested, and the valuation of the company. 

• Early-Stage Investors: These investors, including angel investors and seed funds, often receive a higher percentage of equity for a relatively small investment due to the high risk involved. They might also receive convertible notes that convert into equity at a later stage. 
  

• Venture Capitalists: As the company grows, venture capitalists provide larger investments but also demand significant equity and often a say in company decisions. Terms like liquidation preferences, anti-dilution provisions, and board seats are common. 
  

• Dilution Management: It's important to manage dilution carefully to ensure that founders and key employees retain enough ownership to remain motivated. 
  

Advisory and Board Equity 

Advisors and board members can provide invaluable expertise and networks and offering them equity can be an effective way to compensate them. 

• Advisory Shares: Advisors typically receive a small equity stake, often in the range of 0.1% to 2%, depending on their involvement and the value they bring. 
  

• Board Members: Board members, particularly independent directors, may also receive equity compensation, though it tends to be higher than that for advisors due to their fiduciary responsibilities and ongoing commitment. 
  

Analysis and Discussion 

Equity compensation, like vesting schedules and share options, can greatly impact a startup's success. Equity incentives help employees align their interests with the company's goals, motivating them to help the startup grow and succeed. However, it’s important to consider the potential downsides, such as dilution of ownership and the tax implications for both the company and its employees. 

Share options can motivate employees, but they can also lead to complicated tax situations when employees use them. Companies need to consider the benefits of offering equity. They also need to think about the possible financial burden and the reduction in their ownership. 

Example 

Consider a scenario where a tech startup offers share options to its first few employees. The company sets up a four-year vesting schedule with a one-year cliff to ensure that employees commit to staying at least a year.  

One of the early hires, after completing the one-year cliff, decides to leave the company in the second year. The vesting schedule means the employee only gets a little bit of the company's ownership over time. This helps the company keep control of its shares in case the employee stops helping it grow. 

Another example is a company that provides options to attract top talent. The tax benefits of options make them attractive, but the employee should consult a tax professional to understand the potential tax consequences of exercising their options and selling the shares. 

The Final Word 

Understanding and structuring startup equity, vesting schedules, and share options are essential for building a successful business. These tools help attract and retain talent, align interests, and provide financial incentives that drive growth. However, it’s crucial to get the details right to avoid pitfalls that could harm both the company and its employees. Consulting with legal and financial experts can help ensure that your equity compensation plan is structured effectively and compliantly. 

At Allied Legal, we specialise in providing expert guidance on all aspects of startup equity. Whether you're a founder setting up your first vesting schedule or an employee navigating your share options, we're here to help you make informed decisions that support your long-term success. Contact us today to learn more about how we can assist you with your equity compensation plan.