Posted on March 28, 2016
Getting a Piece of the Action – Equity in Employment Contracts
Employees below “C level” (CEO, CFO, etc.) are unlikely to get rich on their salaries alone.
The more usual way to make serious money from a job is to get some form of equity-based compensation.
Employee equity is often granted via an Employee Stock Ownership Plan, or ESOP. About 7,000 companies in the US have such plans, and more than 13 million employees benefit from them.
With equity-based compensation, the employee gets shares of the company either instead of or in addition to cash compensation. As a result, the employee owns part the company.
The employee can be given:
- Common Stock – This stock pays dividends (a percentage of profits) when the company makes money.
- Preferred Stock – The holders of this type of stock get paid dividends before holders of common stock.
How Stock Options Work
With a stock option, the employee isn’t given stock outright. Instead, the employee has the opportunity to buy shares later, but at a previously set price. Buying the stock is called “exercising the option.”.
For example, a company might offer an employee the ability to buy ten shares of stock at $10/share in five years. After the five years pass, the employee can buy the 10 shares for $100 regardless of the current market price of the stock.
If the current market value of the 10 shares of stock is now $18 per share or $180 total, the employee can sell those ten shares for $180 and reap a profit of $80.
However, if the stock is worth only $9 per share, then the 10 shares are worth only $90 and the options are said to be “under water.”
What You Can Negotiate With Stock Options
People are usually in the strongest position to negotiate equity before they’ve signed their employment agreements.
Some negotiating points include:
- What’s the “strike price” for the stock options? (This is the price you pay for the stock when exercising your options. Obviously, the lower the better.)
- What’s the “vesting period” for the stock? (Stock options usually vest over time. For example, you might have 100 shares vesting over four years, with 25 shares available for you to buy by the end of the first year, 50 by the end of the second, etc.)
- If you’re terminated without cause, are you entitled to “accelerated vesting”?
- Are you entitled to accelerated vesting if the company is sold?
- Do you have to come up with the cash to exercise the options (buy the stock)? Or does your employer allow a “cashless exercise,” where you take out a very short-term loan and then pay it back when you immediately sell the stock you buy with the loan?
Why Companies Give Equity
Startup companies, in particular, are generally short on cash and unable to pay high salaries. Yet they need to attract top-notch talent. Equity-based compensation helps bridge the gap, but it’s a gamble for the employee.
Once an employee has an ownership interest in the company, it’s assumed that the employee will work harder and that the company will flourish as a result.
Equity based compensation can thus be a win-win for employers and employees, since everyone benefits from the company’s success.
Understanding Which Equity Terms Are Standard in a Contract
If you have friends already working in startups, you may want to ask them about how they dealt with negotiating equity and protecting their interests. It’s also a good idea to talk to a lawyer experienced in this area.
Another option is reviewing your contract online. The quickest and most affordable way to check what terms are standard in your employment contract is by uploading it to the LawGeex contract review solution. Whether or not your contract includes equity-based compensation, it’s important to understand your employment contract before you sign it.
Getting a piece of the action (i.e., equity) for all the hard work you put into the business is a good idea, especially for a startup that looks like it’s on the way to big profits. But before you sign, review your contract and see how it compares to others.