Editor’s Note: A version of this article was previously published by Forbes.

If your early-stage startup is looking to bring on passionate, dedicated employees, equity compensation can help you build a team that is committed to making the business a success. 

Employee equity is the practice of granting stock to employees as part of their compensation packages. If the value of this equity multiplies year-on-year as the startup’s valuation grows, having a stake in the business can become a huge financial asset for the employee in the future. By offering equity to new hires, startups can conserve their cash and attract top talent who have a longer-term vision for their role with the business. Plus, because employees who own equity are invested in the success of the startup, you can be confident they will work hard to ensure it scales.

In this article, we’ll cover the basics of how your business can grant startup employee equity.

Looking for expert help managing your early-stage startup’s finances? Click here to book a demo with Zeni.

5 Steps To Offer Startup Employee Equity 

1. Create an Employee Stock Option Pool, or ESOP. 

A general rule of thumb is to set aside around 10-15% of your equity for your Employee Stock Option Pool (ESOP) which is dedicated for future employees. However, you can increase the amount of equity assigned to the pool as you distribute the equity and the pool diminishes. 

For example, post your Seed round, you may assign half the available stock options in the pool over the first 18 months of operation, leaving only 5% of the ESOP remaining. To allow enough equity to accommodate future employees, you can allocate more equity to your employee stock option pool by diluting the shares of existing shareholders—slightly reducing the percentage of the business they own. Startups often replenish the employee equity pool as part of a funding round. 

2. Choose the type of equity to grant. 

Startups grant three main types of equity to employees: 

  • Stock options are the right to buy or sell a defined amount of shares from the founders at a predetermined price. The employee can exercise this right between the vesting date (once the employee has earned their stock options) and the expiration date. This is the most common type of equity that startups choose to distribute to employees.
  • Stock warrants are the right to buy or sell a defined amount of shares from the company at a predetermined price. Warrants can also only be exercised between the vesting and expiration dates, but they usually have longer expiration dates than stock options.
  • Stock grants are the ownership of a defined amount of stock. There is no vesting date or expiration date on stock grants, so the employee can immediately sell the shares, if they so choose.

3. Determine the vesting period.

The vesting period is the time during which an employee must earn (or vest) their allocated stock by working for the company. The typical startup equity structure is graded on a four-year vesting period, which means the employee earns ownership of 25% of their stock each year. The vesting period also often includes a one year cliff period—the minimum time the employee must stay with the company before the vesting schedule begins. A small number of companies choose to have longer vesting periods or increase the percentage of equity that employees vest each year to disincentivize employees from leaving the business.

What happens to equity when an employee leaves a startup?

If an employee decides to leave a startup and a portion of their shares have vested, they typically have 90 days after leaving the company to buy or exercise their stock options. If they choose not to, then they lose the stock options and their stock options are added back to the employee stock option pool.

4. Decide how much equity to assign to each employee.

How much equity should a startup employee get? Some startups determine the amount of equity they grant to each employee based on the seniority of their role, while others offer equal amounts of equity regardless of hierarchy. 

Because a high percentage of startups fail at an early stage, early startup employees take on a significant risk when they join the company—and most businesses offer more equity to early employees to reflect this fact. For example, you might offer 1% equity for the first 10 employees and 0.5% equity for the 50th employee.

How to determine value of your startup equity

To determine the value of your startup equity, ownership and equity management platform Carta notes you’ll need the following figures:

  • Last preferred price (the last price per share for preferred stock)
  • Post-money valuation (the company’s valuation after the last round of funding)
  • Hypothetical exit value (the value the company could exit at)
  • Number of options in your grant (the total number of options offered to you)
  • Strike price (the price per share to exercise your options)

Read more and check out their calculator tool on the Carta blog.

Read more and check out their calculator tool on the Carta blog.

5. Document startup employee equity in a cap table.

A capitalization table (or cap table) is a record of all the shareholders of your company, including any employees, advisers, or investors who have equity (this might include friends and family, angels, or VCs who’ve invested in your business along the way). 

Your cap table should include the total number of stock options that have already been exercised and the total number of shares still available in the option pool. Make sure to regularly update this document to ensure it’s an accurate reflection of the company’s current ownership. As well as being a key financial document to share with potential investors, an up-to-date cap table will help inform strategic business decisions about the fundraising process.

Startup Employee Equity Terminology

  • Vesting Schedule is a preset schedule that determines when employees can take advantage of their stock options.
  • Cliff Vesting is when an employee becomes fully vested on a specified date rather than becoming partially vested in increasing amounts over an extended period. Typically, plans have a four-year vesting schedule plan with a one-year cliff. Upon completing the cliff period, the employee receives full benefits,” (Investopedia).
  • Accelerated Vesting allows an employee to gain access to the company stock or stock options they’ve been issued at a faster rate than the typical vesting schedule.
  • Incentive Stock Options (ISO), also known as Qualified Stock Options, are a type of stock option issued only to employees that are taxed at the capital gains tax rate, which is lower than ordinary income tax rates.
  • Nonqualified Stock Options (NSO) are a type of stock option issued to employees that are subject to ordinary income tax rates, based on the difference between the grant price and price at the time of exercising the option.
  • Liquidity Event is a transaction—such as a merger, acquisition, or initial public offering (IPO)—that enables owners and shareholders to earn the value of their investment.
  • Preference Stack is the predetermined order of which stakeholders in a business will be paid first when a startup is sold, or at the time of a liquidity event.
  • Option is the right to buy or sell the stock at a specific price and specific date.
  • Stock represents shares of ownership.
  • Strike Price is how much an employee will pay to purchase a single share of their company when they exercise a stock option.

Need guidance from startup experts as you grow? 

At Zeni, we have first-hand experience of what it takes to run successful startups, so we understand how complex and time-consuming it can be to manage all your own finances. Zeni is a modern, full-service finance firm that can handle all your bookkeeping, accounting, and CFO needs, freeing up founders to focus on growing their business. 

Our experienced team of experts knows the world of startup finance inside and out, and can guide founders through every aspect of business accounting, from building your financial model to choosing the right software for your business. Plus, with Zeni’s CFO Plan, you’ll get a dedicated CFO advisor with experience in your business vertical who can manage your financial planning and analysis, prepare key financial reporting, and advise on startup equity and the fundraising process. 

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