Equity Compensation and Vesting Schedules: Building Incentive Structures
Master equity grants. Design vesting schedules, grant options, align incentives.
Key Takeaways
- Equity basics: Stock options (right to buy at strike price), ISOs vs NSOs (tax treatment differs), vesting schedule (earn over time). Purpose: Retain talent (can't leave before vesting), align incentives (benefit from company success), conserve cash (pay with equity instead of salary). Vesting structure: 4-year vest with 1-year cliff (earn 0% year 1, then 1/48 each month after). Example: 100K options, 4-year vest, 1-year cliff = 0 after year 1, 25K after year 2, 50K after year 3, 100K after year 4. Cost: Shares dilute founders but minimal if granted thoughtfully.
- Option pool sizing: Set aside 10-20% for employee options (standard 15%). Example: 1M shares total, 150K option pool. Exercise price: Set at fair market value (FMV) at grant (audit-proof). Vesting terms: 4-year vest, 1-year cliff (standard). Early exercise: Let employees buy vested shares before resignation (saves taxes). Acceleration: Full vest on exit (acquisition) if included in offer letter (controversial, but common). Cost: Track carefully (ASC 718 expense = dilutes earnings).
- Tax treatment: ISOs (incentive stock options) = better tax (capital gains), NSOs = ordinary income tax. Strategy: ISOs for employees <£10M options granted, NSOs for large grants or non-employees. Timing: Exercise early if cheap (lower tax cost). Hold 2+ years post-exercise for ISO tax treatment. Example: ISO £2 strike, stock worth £10, exercise gains £8, hold 2 years, sell at £15 = £13 capital gain (better tax). Cost: Track ISO limits (£100K FMV per year), exercise timing carefully.
Designing Equity Compensation Programs
Retaining talent with equity. **Understanding equity grants** Types of equity: - Restricted stock: Shares issued immediately, vesting over time - Pros: Simpler accounting, immediate ownership - Cons: Tax hit upfront (FMV at grant) - Use for: Early employees, founders - Stock options: Right to buy shares at set price (strike) - Pros: Upside if share price rises, better tax treatment - Cons: Requires cash to exercise, complexity - Use for: Most employees (standard practice) - Phantom shares: Cash payout based on share value - Pros: No equity given away (retention via cash) - Cons: Cash expense, not real ownership - Use for: When don't want dilution (rare) Exercise price (strike): - Set at fair market value (FMV) on grant date - Example: Company worth £5M, 1M shares = £5 per share strike - Must document FMV (409A valuation for tax compliance) - Cannot be below FMV (tax rules) Vesting schedule (standard): - 4-year vest: Earn equity over 4 years - 1-year cliff: Nothing vests year 1, then monthly after - Timeline: - Month 0-12: 0% vested (cliff period) - Month 12: 25% vested (cliff date) - Month 13-48: 1/48 each month - Month 48: 100% vested - Example: 100K options - After 1 year: 0K vested (cliff not hit if left) - After 2 years: 25K vested - After 3 years: 50K vested - After 4 years: 100K vested **Option pool and sizing** Standard sizing: - Early stage (seed): 20% pool (larger for team building ahead) - Growth stage (Series A+): 15% pool (smaller as larger cap table) - Formula: 15-20% of total shares reserved for employees Example cap table with option pool: | Party | Shares | % | Notes | |---|---|---|---| | Founder A | 400K | 40% | Full vesting | | Founder B | 400K | 40% | Full vesting | | Option pool | 150K | 15% | Reserved for employees | | Early investor | 50K | 5% | Seed round | | Total | 1M | 100% | - | Granting strategy: - New hire: £50K-200K range depending on level/stage - VP-level: 0.5-2% of company (£5-20K shares) - Senior engineer: 0.1-0.5% (£1-5K shares) - Junior engineer: 0.05-0.15% (£0.5-1.5K shares) - Non-technical: 0.05-0.2% (£0.5-2K shares) Example: 1M share company | Role | Expected % | Shares | FMV at £5/share | Value | |---|---|---|---|---| | VP Sales | 1% | 10K | £50K | - | | Senior eng | 0.25% | 2.5K | £12.5K | - | | Mid engineer | 0.1% | 1K | £5K | - | | Junior | 0.05% | 0.5K | £2.5K | - | **Vesting mechanics and acceleration** Typical vesting terms: - Vest period: 4 years (standard) - Cliff: 1 year (all-or-nothing at 1 year mark) - Acceleration: Full vest on acquisition (negotiable) Cliff impact: - If quit month 13: 25K vested (loss £75K if month 12 quit) - If quit month 24: 50K vested - Protects company (retain year 1) Acceleration types: - Single-trigger: Automatic on acquisition - Example: Acquired at month 24, all 100K grants fully vest - Pro: Founder retains full upside - Con: Expensive, reduces acquisition attractiveness - Double-trigger: Acquisition + job loss required - Example: Acquired, employee stays 6 months, loses job = accelerate remainder - More common (employer-friendly) - Partial acceleration: Vest X% on acquisition (compromise) - Example: 50% acceleration + new employment agreement Early exercise: - Allows employees to exercise vested portions immediately - Benefit: Tax advantage (time to hold before sale) - Example: Exercise 25K shares at £5 strike = £125K cost - If hold 2+ years and company sells for £15/share - Stock gains: (£15-£5) × 25K = £250K (capital gains, better tax) **Cap table and dilution tracking** Post-Series A example: | Party | Pre-A | Post-A % | Post-A Shares | |---|---|---|---| | Founder A | 40% | 30% | 300K | | Founder B | 40% | 30% | 300K | | Option pool | 15% | 11% | 110K | | Early investor | 5% | 4% | 40K | | Series A investor | 0% | 25% | 250K | | Total | 100% | 100% | 1M | Employee grants from pool: - VP Sales: 0.5% of post-A = 5K shares - 3 senior engineers: 0.15% each = 1.5K shares each = 4.5K total - 2 mid engineers: 0.1% each = 1K shares each = 2K total - 3 junior: 0.05% each = 0.5K each = 1.5K total - Total pool usage: 5 + 4.5 + 2 + 1.5 = 13K / 110K = 12% of pool (leaves 97K for future) **Accounting and tax considerations** ASC 718 (stock-based compensation): - Expense recognized over vesting period - Cost: Value at grant date / vesting months - Example: 10K shares at £5 FMV, 4-year vest - Total expense: £50K spread over 48 months - Monthly P&L impact: £1,042 (non-cash, but P&L hit) - Dilutes earnings but non-cash (important for VC metrics) Tax treatment: - ISO (incentive stock option): - Tax on gain when sold (capital gains rates) - Requires 2-year hold to qualify - Limited to £100K FMV per year - Better for employees - NSO (non-qualified option): - Tax at exercise (ordinary income on gain) - Exercised at £5, stock worth £10 = £5 × shares = taxable income - Then capital gains on further appreciation - Used for large grants or non-employees Strategy: - Grant ISOs up to £100K limit - Use NSO for amounts over limit - Early exercise allows long-term holding before liquidity event - Track 83(b) elections (if restricted stock)