Equity Incentive Plans
To build a successful startup, you need to attract top talent while preserving precious capital for growth. For many founders, this creates a dilemma: how do you compete for skilled employees when cash flow is tight and established companies can offer higher salaries?
The answer lies in equity incentive plans or EIPs—a form of non-cash payment that grants an employee an ownership stake in your company. This approach fundamentally changes the employer-employee relationship. Instead of simply trading time for money, team members become invested stakeholders who benefit from increased company value. When your business succeeds, everyone wins!
How Your Startup Can Benefit from an EIP
The advantages of an equity incentive plan go far beyond short-term cost savings. When implemented strategically, an EIP can play a pivotal role in your company’s long-term success by helping you attract exceptional talent, retain key employees, increase cash flow flexibility, and create a culture of shared ownership that drives sustainable growth.
Attract Top Talent
Skilled professionals often accept below-market salaries in exchange for meaningful equity stakes when they believe in a company’s growth potential. This trade-off allows cash-constrained startups to compete directly with larger organizations that can offer higher base compensation.
Early employees understand that equity compensation could generate significant returns if the company succeeds, making startup offers attractive to candidates seeking ownership in their work. The key is to present equity as an opportunity, rather than a sacrifice—helping candidates understand the potential value creation they’re joining.
Increase Employee Retention
A vesting schedule establishes the timeframe over which an employee will gradually gain ownership of their granted assets, and creates a powerful incentive for long-term commitment. When employees have unvested equity tied to continued employment, they think carefully before leaving for other opportunities. This retention mechanism becomes particularly valuable during challenging periods, when competitors might try to recruit your key team members.
All equity grants should include appropriate vesting schedules with cliffs, including founder equity. Standard four-year vesting with one-year cliffs protects your company and demonstrates commitment to investors who expect founder vesting arrangements.
Drive Motivation and Alignment
Equity compensation aligns individual success with company performance. When team members benefit directly from increased valuation, they naturally focus on activities that drive business growth, rather than just completing assigned tasks.
This alignment extends to decision-making. Employees with equity stakes are more likely to consider long-term company impact when making choices, leading to better resource allocation and strategic thinking across all departments. Teams work more collaboratively when everyone’s financial success depends on collective achievement.
Greater Cash Flow Flexibility
Leveraging equity compensation frees up cash for product development, marketing campaigns, and other operational expenses critical for startup growth. Fixed salary costs remain lower while variable equity costs impact the cap table rather than immediate cash outflows. This allows startups to better weather unexpected expenses or revenue fluctuations.
Types of Equity Incentive Plans
Equity compensation comes in many forms, including:
Stock Options
Stock options give recipients the right to purchase company shares at a predetermined price after meeting vesting requirements. This approach works well for startups because options don’t require immediate tax payments, and they allow employees to benefit from company growth without upfront costs. Stock options are structured as either Incentive Stock Options and Non-Qualified Stock Options, as discussed below.
Incentive Stock Options (ISOs)
ISOs are only available to employees and offer favorable tax treatment when structured correctly. Recipients pay no tax when exercising options, and gains can qualify for capital gains taxation rather than ordinary income if holding requirements are met.
Non-Qualified Stock Options (NSOs)
NSOs can be granted to employees, contractors, and advisors, but they don’t offer the same tax advantages as ISOs. Recipients pay ordinary income tax on the difference between exercise price and current stock value at the time of exercise.
Restricted Stock Awards (RSAs)
RSAs are grants of actual company shares with restrictions like vesting schedules or performance requirements. Recipients become immediate shareholders but cannot sell or transfer shares until restrictions end.
Restricted Stock Units (RSUs)
RSUs promise to deliver stock or cash value upon vesting, rather than granting immediate shares. However, most early-stage startups avoid RSUs due to complexity and immediate tax implications upon vesting.
Phantom Units
Phantom units track a company’s value appreciation without granting actual ownership. Recipients receive cash payments based on company valuation increases during specified periods, typically triggered by events such as funding rounds, acquisitions, or IPOs where the company’s value is formally established.
Stock Appreciation Rights (SARs)
SARs provide cash or stock payments equal to the appreciation in company value over a specified period. Recipients benefit from stock price increases without purchasing shares or becoming shareholders.
Best Practices for Implementing an EIP
Plan Equity Early
Create your cap table from the beginning and allocate shares for founders, employee option pools, and future hires. By planning early, you can avoid scrambling later or over-promising equity when you don’t have sufficient shares available, or when the exercise on the value of the stock has increased.
Prioritize Transparency
When offering equity to employees or co-founders, explain exactly what the numbers mean in context. Avoid vague promises and always explain how dilution will affect ownership percentages during future funding rounds. Provide clear documentation showing current cap table ownership, expected dilution scenarios, and potential value outcomes.
Use Standard Vesting for Everyone
Maintain consistent vesting schedules to ensure fairness across your team and simplify plan administration. Use custom vesting arrangements only when justified by unique circumstances, as the added complexity can increase both legal costs and administrative burden. In addition, the determination of whether complex vesting milestones based on KPIs have been achieved can often lead to disputes.
Don’t Over-Dilute
Avoid giving away too much ownership in early stages. It’s tempting to offer large equity stakes to early hires or advisors, but you’ll need to plan for shares to be available for future executives, investors, and key team members.
Re-evaluate Regularly
As your company grows and market conditions change, review whether your equity grants remain competitive with market rates. Use third-party compensation data to ensure your offers attract top talent while preserving appropriate ownership for founders and investors. Plan on refreshing grants to reward employees who complete their initial vesting schedules and continue to contribute to company growth.
Document and Track
Use professional cap table management tools to track all grants, vesting schedules, and ownership changes. Maintain records of board approvals and signed agreements, as administrative errors in equity can lead to serious disputes and legal issues.
Proper documentation becomes crucial during due diligence processes for funding rounds or acquisitions. Investors expect clean cap tables with clear ownership records and compliant equity grant procedures.
How NEXT Can Help You Implement an EIP
If you’re ready to implement an EIP for your startup, NEXT’s fixed-price Equity Incentive Plan Package can simplify the process:
- Complete Equity Incentive Plan drafting and implementation
- Model Grant Agreement templates for consistent equity awards
- Model Stock Option Agreement for option grants (ISO’s and NQSOs)
- Model Exercise Agreement to facilitate option exercises
- Model Restricted Stock Agreement for direct equity grants
- Model Early Exercise Agreement for option grants with early exercise
- Strategic consultation on vesting schedule design and implementation
- Board Consent resolutions for plan approval
- Stockholder Consent documentation when required
From selecting the right plan to deciding which employees may participate, our experienced startup attorneys will help ensure your EIP aligns with both your funding goals and your vision for growth.
Take the Next Step
Equity incentive plans can help founders compete for talent and foster a culture of ownership where everyone wins, provided they’re implemented correctly. The decisions you make about equity structure, vesting schedules, and allocation strategies will impact your company’s trajectory for years to come.
Ready to implement an EIP? Contact NEXT today to learn how we can help.
