Equity Incentive Plans15Aug2022
1. What is an equity incentive plan?
An equity incentive plan is a scheme adopted and approved by a company that sets out rules that apply to a contract between a company and an individual to provide the individual an interest in or linked to the shares of the company. The individual can be an employee, director, advisor or consultant of the company. The purpose of an equity incentive plan is to incentivize these individuals by the increased value of the business that arises from their future performance. This also has the effect of encouraging key people to remain with the business.
An equity incentive plan can be in the form of a long form agreement with each individual or a set of scheme rules for all participants with a short form grant agreement with each individual.
There are many forms of equity incentive plans. I will discuss briefly employee share option plans, which are the most common form of plans we see.
2. Employee share option plans
Under an employee share option plan, the company grants the participant an option which gives the participant a right to exercise the option to purchase shares in the company at a pre-determined price during an exercise period. Typically, options will vest according to a vesting schedule.
An employee share option plan has a number of positive features. The vesting schedule is a mechanism to encourage the participant to remain with the company for the duration of the vesting schedule. This supports employee retention. The interests of key persons will be aligned with those of the company as key persons have the prospect of benefiting directly from future increase in the value of the business.
There are challenges with employee share option plans. It is difficult to value the market price of shares of a private company. This has a consequence both in determining the grant allocation to be made to each key employee and in setting the exercise price for the grant. The company also should consider how it will manage its capitalization table if options are exercised and participants are issued shares. Many shareholders create an administrative burden on the company.
Share options should generally be granted in respect of non-voting shares so grants will not dilute control or voting rights. The company will need to consider how to deal with options and shares issued on exercise if employees leave the company.
3. Common mistakes to avoid
These are some common mistakes we encourage companies to avoid:
- Specific factors: Each company has a different need for an incentive scheme. These need to be considered and factored into the terms of the equity incentive plan.
- Dilution: Options are not free. An employee share option plan will have an effect on the capitalisation table, amounts to economic dilution and will impact how investors approach valuations.
- Employee engagement: The company should make sure that the employee share option plan will represent an incentive that its key persons actually value and want. The company should also co-ordinate employee engagement through the process of adoption and initial grants, particularly as the legal documents presented to employees for signing are lengthy and complex.
- Tax: The grant and exercise of share options can have a tax consequence both for the company and the employee. This should be assessed as an initial step.
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Disclaimer: This publication is general in nature and is not intended to constitute legal advice. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.