In my practice, I frequently provide advice on a specific area of law: stock option plans, or as I prefer to refer to them, equity compensation plans.
Since this is just an introduction, I will focus on two common topics that founders frequently inquire about when considering an equity compensation plan:
- What types of equity compensation can be awarded?
- Where do the shares come from?
Types of equity compensation
In this blog, I will not be able to cover all the different types of equity compensation. Instead, I will discuss two of the most prevalent options: stock options and restricted share units (RSUs).
Stock options are often the first type of equity compensation that founders inquire about. They are a suitable choice for companies ranging from early-stage start-ups to large public corporations.
Typically, a stock option grants the recipient the right (but not the obligation) to purchase securities of the corporation at a predetermined exercise price. These options usually have a vesting schedule and must be exercised within a specific timeframe, usually five to 10 years. Until the stock option is exercised, the recipient does not hold any shareholder rights. One appealing aspect of stock options is their potential for favorable tax treatment when granted under a well-structured plan.
On the other hand, restricted share units (RSUs) entitle the recipient to receive securities in the corporation once the RSUs vest. Unlike stock options, there is no decision to be made regarding acquiring the securities, and no payment is required to obtain them. Similar to stock options, the recipient of an RSU does not become a shareholder until the RSU vests, and the recipient officially becomes the owner of the corresponding securities. However, it can be more difficult to structure RSUs to achieve the same favorable tax treatment that stock options receive.
There are other types of equity compensation you may have heard of, such as Performance Share Units, Deferred Share Units, Phantom Share Plans, and Share Appreciation Rights. If you want more information about any of these types of equity compensation, I encourage you to reach out to a member of our business law team.
Establishing an equity compensation plan pool
Now that we have covered the types of equity compensation, I will discuss how a plan is formed and where the equity comes from. Some of the initial questions I am often asked about equity compensation plans are:
- Why do I need a formal plan?
- Where do the securities for the plan come from?
- How will this affect my ownership?
There are several reasons why plans are necessary. Firstly, a formal plan is required to take advantage of preferential tax treatment available for certain types of equity compensation. Secondly, a plan is a comprehensive document that covers details that do not need to be repeated in each award agreement—an award agreement being the agreement between the company and an award recipient granting them their equity compensation. Notably, it is possible to set up equity compensation plans that cover multiple types of awards.
To establish an equity compensation plan, a corporation must allocate a certain number of securities to be awarded under the plan. These set-aside securities are commonly referred to as a stock option pool or an equity compensation pool.
There is no fixed formula for determining how many securities should be set aside. It is common for corporations initiating their first equity incentive plan to allocate a pool equal to five to 15% of the corporation's outstanding equity. However, various factors need consideration when determining the appropriate allocation, including the current ownership structure, founders' investments, the corporation's use of equity compensation alongside other forms of compensation, and the potential for future equity investment in the corporation.
An equity compensation pool, when set aside, does not dilute the actual ownership interests of shareholders. However, it does impact the fully-diluted ownership percentages of existing shareholders.
If you are unfamiliar with fully-diluted ownership percentages, they calculate the ownership interest of each shareholder (or potential shareholder) of a corporation by considering all contingent rights to securities, including various types of equity compensation, when they convert into securities.
To illustrate this concept in a simplified manner, let us consider a corporation with a single founder who owns 100% of the corporation's securities. If the corporation establishes an equity compensation pool equal to 10% of the securities on a fully-diluted basis, the founder's fully-diluted ownership percentage would be 90%. However, the founder's actual ownership percentage will remain at 100% until the equity compensation awards start converting into securities. As the awards convert, the founder's actual ownership percentage will gradually decrease with each issuance of securities, reaching a maximum of 90%.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
