What is the standard protocol for granting equity compensation?

Takeaway: The process is generally ensuring your 409A valuation is valid, figuring out how many shares are available for issuance under the equity incentive plan, deciding how many shares/options to issue, having the board of directors approve the RSA/option grants, having the recipients sign the RSAs/option grant paperwork, and updating your capitalization management platform (e.g., Carta) to reflect the grants.

Issuing equity compensation, such as stock options or restricted stock awards, is a common way for startups to incentivize and retain top talent. However, the process of issuing equity compensation can be complex and requires careful planning and execution to ensure that both the company and its employees benefit. Here's a look at the standard protocol for startups issuing equity compensation to employees and consultants.

Determine the shares available in the equity incentive plan

Before issuing any equity compensation, the startup must determine how many shares are left in its equity incentive plan. This is typically expressed as a percentage of the fully diluted capitalization of the company and represents the maximum amount of equity that can be issued to employees and consultants. If there are not enough shares in the equity incentive plan to cover all the contemplated grants, the company will need to add more shares to its equity incentive plan, which may involve making a filing in its state of incorporation to amend its charter.

Obtain 409A valuation

Under IRS regulations, equity compensation must be granted at fair market value in order to avoid tax penalties. To determine the fair market value of the company's stock, startups typically obtain a 409A valuation from a qualified valuation firm. If the company does not have a valid 409A valuation at the time, it will need to get one before issuing any equity compensation under its equity incentive plan. Please see this post and also this one for a discussion of 409A valuations.

Grant equity awards

Once the number of shares available in the equity incentive plan has been established, the startup can begin granting equity awards (whether restricted stock awards or stock options) to eligible employees and consultants. This typically involves (i) drafting a board consent where the company’s board of directors reviews and approves the grants, (ii) executing an equity award agreement, which outlines the terms and conditions of the award, including the vesting schedule, exercise price, and any other restrictions or conditions, (iii) making any applicable securities law filings, and (iv) updating the capitalization table. Typically, the company’s lawyers are very involved in this process and have a lot of experience issuing equity compensation.

Track and Manage Equity

Once equity awards have been granted, the startup must track and manage the equity on its cap table. This includes keeping accurate records of the number of shares issued, the vesting schedule for each award, and any other restrictions or conditions. Often, the company’s lawyers (usually a paralegal) will update the capitalization table. If the company uses Carta, the employee or consultant will receive a notification that their equity compensation has been issued.

Conclusion

Understanding the process for issuing equity compensation to your startup team is important. It's also necessary to diligently update your capitalization management platform, such as Carta, for accuracy and seamless tracking of all equity grants. Remember, a well-managed equity compensation process can play a key role in your startup's ability to attract, retain, and motivate the best talent.