are company policies that provide money or other benefits to company officers and selected employees in excess of their salaries.
Most companies seeking venture capital cannot afford compensation and bonus plans that require them to use cash. At the same time, however, growing companies need incentives to attract and keep valuable employees. In many instances, they need their key employees more than their established competitors need theirs. This is because the smaller size of the entrepreneurial company makes each employee more important. Unfortunately, though, the entrepreneurial status of the company also means less job security and, usually, lower salaries.
To offset these hiring disadvantages, most start-up companies use their stock and its relatively low market value to attract key employees. They do so by offering important employees the opportunity to acquire equity in the company. The attraction for the employee is the chance to purchase quantities of stock at low prices in anticipation of the company growing and the stock increasing in value.
Young companies take advantage of their inexpensive stock by fashioning compensation and bonus plans around the right to acquire shares of company stock. The most widely used plans are ones that allow key employees to purchase company stock or acquire options to purchase it in the future.
Often, the grants of stock or options are conditioned in ways that encourage the employee to remain with the company after the stock is purchased. For instance, shares of stock purchased pursuant to a plan may not "vest" immediately. Instead, they may vest over a period of years. During the vesting period, the company may have an option or obligation to repurchase the unvested shares from the employee at cost if he leaves the company for any reason. The company may even have rights to repurchase a departing employee's vested shares for some predetermined price. All of these conditions are designed to reward the employee who stays by increasing his ownership in the company and to penalize those who leave.
With stock option grants, the company may make them exercisable at today's low prices but contingent upon some future event. The employee's right to purchase shares may be restricted until he has been with the company for a year or until the company attains certain sales goals. Once the exercise conditions are met, the employee can purchase the stock until the option's expiration date. If the conditions are not met, the option dies and the employee gets no stock.
Often, options are made to become exercisable in increments over a period of several years. For example, an option to purchase 10,000 shares of company stock might be structured to become exercisable as to 2,500 shares on each of the first four anniversary dates of the option grant. In this way, the employee would have to remain for four full years before he could purchase the full 10,000 shares. If he left during the third year, he would be entitled to purchase only 5,000 shares.
Other common plans include issuing "phantom stock" and granting options to purchase special classes of stock. Grants of stock bonuses to employees from a pool of shares set aside for that purpose are used also. The variety of plans available to attract important employees is limited only by the imaginations of management and its advisers. A good adviser can help management select an incentive plan (or plans) that reward employees in ways that secure their attention, enthusiasm, and tenure with the firm.
Careful consideration of potential tax consequences is essential to selecting an effective incentive plan. To minimize unwanted tax consequences to the employee and the company when stock is granted or options are exercised, many growing companies fashion their initial incentives from qualified incentive stock options or vesting stock plans or a combination of both. Qualified tax advisers should always be consulted before granting stock or options to employees. See: ISO’s (Incentive Stock Options), Qualified Stock Option Plans, Vesting Stock Grants. See also: Golden Handcuffs, Junior Common Stock, Phantom Stock Plans, Stock Committee, Vesting Schedules.