There are several different ways to implement a long term company performance-based compensation plan to attract, motivate, and retain key employees. I’m going to lay out the key questions you’ll need to answer when coming up with such a plan here, together with potential answers that I’ve seen applied in practice. I’m not going to suggest any specific “correct” answer because the right arrangement depends on the resources of your company and the specific employee behaviors you’re trying to incentivize.
Equity: These are actual shares in the business, together with the corresponding economic and voting rights of the share class. Employees are almost always given common shares that don’t carry any preferential rights like board seats or liquidation preferences.
Options: These are the right to purchase shares of the company at a predetermined price known as the strike price. In this case, the economic value of the shares that the employee receives if they choose to exercise the option is the share price minus the strike price. Because the employee only pockets the difference between the share price and the strike price rather than the full share price, option grants require a greater number of underlying shares to produce the same economic value as equity grants.
Phantom shares: I’ve only seen these used in Turkey, not in the US. They’re essentially rights to the same economic value as actual equity, but they don’t carry any voting rights. They don’t appear on the cap table but are included in the calculation of the distribution of the exit proceeds. Since their economic value isn’t awarded to the employee until the ultimate exit, they allow the employee to delay the tax liability which comes from receiving actual shares at each vesting date until the ultimate exit date.
It’s useful to think of how much long term company performance-based compensation to offer an employee based on their total compensation package. If we think of total compensation as a combination of salary, cash bonuses, and equity (I’m using this as a catch-all for the equity, option, and phantom share instruments discussed above), all else equal, the greater the employee’s importance and potential impact on the long term success of your company, the greater the weight you’ll want to place on the equity component.
For example, an entry level employee may be fully compensated through their salary and perhaps a small cash bonus. On the other hand, senior level employees who are necessary for and can make a significant contribution to the long term success of your company may have a compensation package with a greater equity weighting than a salary and cash bonus weighting.
As a concrete example, let’s take a key C-level hire to whom you want to offer a total $100K package. If we want 40% of their total compensation to come in the form of salary and cash bonuses, and 60% to come from equity, this implies a $60K annual equity component. Dividing this by the fair market value of the company (the last round’s valuation, together with an adjustment for the growth which has taken place since then can be a good proxy for this) produces the size of the equity grant. Assuming that your business is worth $30M, the employee gets $60K / $30M = 0.2% equity each year.
The reason why we use the fair market value of the company to determine the grant amount is because we want the economic value of the grant to remain the same if the company’s valuation doesn’t increase (making the grant’s exit value equivalent to its current time cash-equivalent value), while growing larger than its current time cash-equivalent value if the company performs well and its valuation rises.
There are two key components here. The first is the vesting schedule. This specifies when the employee will receive the equity. I wrote about founder equity vesting in an earlier post, and the same principles are valid for employee equity grants. So continuing with our example for the key C-level hire above, if an employee receives 0.2% each year across a 4 year vesting period with a 1 year cliff (the 1 year cliff is a pretty common industry standard, but I’ve seen anywhere between 3 year and 10 year vesting), this means that their total equity package is 4 * 0.2% = 0.8%. They earn their first 0.2% only upon completing their first full year at the company (the 1 year cliff), and the remaining on a monthly, quarterly, or annual basis until they’ve received the full 0.8% by the end of the fourth year (the 4 year vesting period).
The second component describes what happens due to differences in the timing of the exit and the equity vesting schedule. If an exit takes place before all of the employee’s shares have vested, there are three possible outcomes. First, the employee can get the economic value of only those shares that have vested. Second, the employee can get the economic value of all of their shares, including those that have yet to vest. This is called single trigger accelerated vesting because there is a single trigger, namely the sale of the company, which causes all of the shares to immediately vest. Third, the employee can get the economic value of all of their shares, including those that have yet to vest, only if the acquiring party terminates their role at the company post-acquisition. This is called double trigger accelerated vesting because there are two triggers. The company needs to be sold and the buyer needs to terminate the employee.
If an exit takes place after all of the employee’s shares have vested, there are two possible arrangements. Either the employee can be required to be at the company at the time of the exit in order to realize their fully vested share of the exit proceeds, or they can realize their fully vested share even if they’re not at the company. In the former arrangement, if the employee is no longer at the company at the time of the exit, they forfeit some of their shares. I’ve seen anywhere between a 100% forfeit (effectively requiring that the employee continue to work at the company until the exit date in order to receive any equity) and a 20% forfeit.