A startup's guide to equity compensation

Working in a startup is like running a marathon with countless hurdles. Getting a piece of the pie motivates potential candidates to join this race (or encourages existing employees to continue it).

And appetite in the UK is growing. A study on the future of compensation in the UK workplace shows twice the number of employees expect share options compared to how many are currently getting.

But how to start rewarding shares? This article covers all the basics of equity-based compensation and the steps to get started to attract candidates to your startup.

What is equity compensation?

Equity compensation means offering shares to incentivise employees or non-employees, such as contractors, advisors, consultants, and freelancers. This type of compensation is usually in the form of:

1. Shares where one gets ownership straightaway, or
2. Share options where the individual can buy shares in the future after fulfilling preset conditions.

And those come in different flavours too.

Why compensate employees with equity? 

Getting equity is known to instil a powerful sense of ownership in employees.

We also reached out to our customers to get a list of the more tangible benefits they observed, and these were the top mentions:

• 93% confirmed that their share scheme helped recruitment efforts.
• 95% agree that it's helped with employee retention.
• 93% say that their scheme has helped company growth.
• 93% believe it's enhanced company culture and aligned the team.

Overall, equity compensation helped in end-to-end talent management and company growth. 

Types of equity compensation

Here are forms of equity compensation you're likely to come across:

1. Ordinary shares

Often referred to as common shares, ordinary shares are the classic form of equity compensation, and the one you're probably most familiar with.

In their most basic form, these shares give each shareholder equal entitlements to capital and sometimes dividends and voting rights too. The value of those ordinary shares is tied to the company's performance.

2. Growth shares

Growth shares are a special class of ordinary shares issued at a hurdle rate, which is a little higher than the current share price. It reflects what we call a hope value.

For example, if a company's share price is valued at £1 and the growth shares are issued at the hurdle of £3, the recipient will only benefit from the capital growth of the business once it exceeds £3.

You can issue growth shares to both employees and non-employees, so everybody can have a vested interest in the company's growth.

Growth shares can also have conditions attached (be those time-based, performance-based or a combination of both). And there are tax advantages too.

3. Preferred shares

Also called "prefs," preferred shares grant their holders the privilege of receiving specific dividend payments before ordinary shareholders. Those with preference shares are also entitled to a portion of your company's assets before ordinary shareholders if it goes into liquidation. (So you can understand why investors often prefer prefs).

4. Share options

Share options give the employee the right to purchase a specific number of shares in your company at a predetermined price once they meet preset conditions.

As the name suggests, it's optional. And they don't become actual shares unless the employee makes the purchase. Usually, they can only make that purchase when they meet specific conditions which are either:

1. Time-based, like staying with the company for a number of years,
2. Performance-based, like an employee meeting targets or the company hitting a specific revenue, or
3. A combination of both.  

There are various share option schemes you can set up. Here are a few:

Unapproved options

Unapproved options are the most flexible share options and can be granted quickly. These share options do not have any tax benefits, so there's no need to seek approval from HMRC. Because of this, you get the name ‘unapproved'.

The key perk of these options is flexibility and speed. There are no statutory requirements which make it easy and quick to reward these options to non-employees or international employees. 

EMI options

If you set up Enterprise Management Incentives, you'll grant employee EMI options, which just so happen to be the most tax-efficient share options in the UK. No wonder it's the most popular scheme of its kind!

Because of those tax advantages, setting up an EMI share option scheme required a HMRC valuation among other things. 

CSOP options

Similar to EMI, the options you grant under a Company Share Option Plan, provide tax savings.

SAYE options

Save As You Earn options are also tax-advantaged, but crucially, linked to three or five-year saving contracts.

How to reward employees with equity

Now you have an understanding of the forms equity compensation can take, here are six steps to take to reward your team:

1. Decide how much to set aside
2. Choose which method of sharing equity
3. Set the vesting period 
4. Issue shares/grant options
5. Educate employees
6. Manage and maintain

Decide how much to set aside

The first step is to decide how much equity to allocate to employees and others. Based on discussions with our customers, their option pools average at 16.7% of their company’s total equity. Anywhere between 5-20% is considered normal. 

And decide then how much to allocate to individuals

The tricky part is deciding how much to give each individual from the pool you've set aside. If you follow the Slicing Pie method, the allocation might look something like this:

• Key early hires: 1-3%
• Senior management: 0.5-1%
• Employees: 0.05-0.5% 

Choose which method of sharing equity

The next step is to decide which type of equity works best for your talent.

• For employees: Generally speaking, share options, particularly the government-backed EMI share options, are hugely tax-efficient for both organisations and employees.
• For advisors, contractors, freelancers and international employees: Growth shares and unapproved options are more flexible to reward non-employees with equity. 

Set the vesting period 

Vesting is how employees earn their shares/options. Time-based vesting is the gold standard as it's easy to implement and understand. Here's an example of a typical vesting schedule:

• Four-year vesting period with a one-year cliff with annual vesting thereafter.
• 25% of the options vest on the cliff and each year after. 

It's main purpose? Employee retention. When equity compensation is subject to vesting, there's an incentive to stay. As well as a schedule like the one above, you can add performance-related conditions too, but it's not always a good idea.

Note: Some share schemes have time limits. For example, employees have to exercise the EMI share options within ten years of the award. 

Issue shares/grant options

Once you've actioned the previous steps, it's time to put your plan into action.

As part of this, you'll design the ins and outs of your chosen scheme and get shareholders' agreements drafted and signed among other things. Depending on which scheme you're introducing, you may have to complete other formalities too such as a company valuation which could take a few weeks.

You could rope in a lawyer, accountant, director, an FD or your CFO to handle all of this for you and issue the shares, or you could save time (and money) and use equity management software such as Vestd.

Educate employees

After you have decided on the type of equity and the percentage, you can set up a company-wide presentation to educate employees. When they understand the benefit of your share scheme, they’re more likely to actively engage with it.

Our free EMI presentation template is a good example that you can download today. We offer customers ready-to-use templates for other schemes too.

The main thing is to be transparent about all of the key details of the scheme, including vesting periods. We say, equity for all! But if you only plan to give equity to selective employees, you can hold one-to-one calls and clarify any queries. 

Manage and maintain

Even once your scheme is set up, you'll need to maintain it, onboard new people, manage leavers, update Companies House, add new valuations, submit annual notifications etc.

Using equity management software saves you from involving the legal team for basic paperwork in every time. (Unless you have a particularly complex business setup). You get a centralised system to manage your cap table and equity compensation.

Plus, with Vestd, shareholders can access their own personalised dashboard. Seeing the value of their shares grow over time makes their future equity reward feel more tangible. Ultimately, this helps you keep your team invested in the company's success.

Three challenges in rewarding equity as compensation

Now, let's discuss where startups often get stuck.

1. It’s complicated (or it can be)

There are many nitty-gritties involved in sharing equity so it's generally perceived to be a huge undertaking. That's why so many founders outsource the task to a specialist, which can become costly (we're talking thousands of pounds).

Yes, it's complicated at times, easy to get it wrong (and those mistakes can be tricky to rectify) but with the right guidance, resources and digital tools, this challenge is easy to overcome. Our great value full-service plan is the best choice for those who want extra support.

2. Tough to manage (but it doesn't have to be)

Many startups still use Excel or Google Sheets to maintain their cap table. As the startup grows, it can get messy with more shareholders and more share issuances as time goes on. It's easy to fall foul of dodgy formulas, rounding errors and plain old human error.

Instead, you can use Vestd to track and manage all your equity issuances. You also get a clear and simple dashboard with a full view of your cap table, schemes, share classes and more.

3. It's another thing to worry about (not necessarily) 

Among other things, directors are legally required to update HMRC of any material changes to the company’s shareholder register. And different shareholders (particularly investors) often have different rights and privileges. So that’s something you’ll need to be aware of and record. 

With government-backed schemes like EMI, there are additional documents to fill out and submit including an annual EMI return. Otherwise, the business and employees risk losing out on the tax benefits.

Staying up to date with all that can feel like heavy lifting for startups, which are often pressed for time. Unless you have a tool connected to Companies House…

Quick recap

There's more to the story. But the steps outlined above should serve as a good starting point, a roadmap for any startup considering rewarding their team with equity. 

The reward for them? A motivated workforce inspired to stick around and help the business succeed. 

Vestd brings multiple pieces of the puzzle together to streamline the whole process. Book a free, no-obligation consultation call with an equity consultant and level up your company's compensation package.