Drafting Equity Compensation Plans

In the last few months, we have been asked to take a look at some draft equity compensation plans in closely held companies. Each was drawn up by an attorney with limited experience doing this. Each had major technical issues that could cause problems down the line. The NCEO does have model equity plan and grant agreements you can use to cross-check the language
(see our list of equity compensation books).

As critical as the legal issues are, there are also common plan design problems. One of the most common is to grant equity in one form or another with a long vesting period (five years or even more unless there is a company sale) and no route to liquidity other than a sale of the company. If you are building your company with plans to sell in the next few years, this can be fine, but if a sale may be years off (or you want to stay private), these provisions will mean the employee will see the grants as almost worthless. Lots of recent research has shown that people tend to value possible benefits that are uncertain and far off at far greater discounts than what a "rational" economic model would tell you.

Say you share 15% of the equity with your employees. Your accountant tells you it is worth $200,000, even with the restrictions. But the employee will probably see a far-off, uncertain award like this to be worth maybe $25,000 to $100,000, depending in part on how much they trust you and in part how risk-averse they are. You have given up $200,000 to provide an incentive perceived to be worth far less. To be sure, providing faster vesting and liquidity can be costly, but in setting up a plan, you need to balance that cost with the fact that making the equity easier to cash in makes the incentive effect per dollar much greater.