Equity Incentive Compensation Companies, founders, and investors all have an interest in getting equity into the hands

of some or all employees and directors. It aligns interests, encourages employees to think and act like owners, and can conserve cash that otherwise would go towards higher salaries.

Vesting Overview Vesting is common mechanism for a founder or employee to "earn" a fixed share or option grant over time. While technically the individual receives the entire amount up front, if he or she leaves the company they are only allowed to take the amount that has vested with them. The company retains any unvested shares. The most common vesting schedule is a "cliff" where 25% vests after the first year, and the remaining 75% vests monthly over the next three years. That way if you hire a key manager but after three months things just aren't working out, you don't have to chase after the paperwork with them for three months worth of vested shares/options. In the US, venture firms often require early stage company founders to submit to vesting as a way to align interests, even though the company may be several years old and they currently own their shares outright. I have found this to be less common in impact investing in emerging markets.

How does vesting align interests? Consider this situation: Three partners found a company and split the equity evenly 33% each. They raise a first round of several million with no vesting schedule. A few months later founder number one (CEO) finds out his wife has been offered a much better job in another city. He ultimately decides that the low pay and 60 hour weeks are putting a strain on his family life, and he leaves the company for a well paying corporate job in the new location. He still owns a big chunk of the company and will get exactly the same payout as the other founders if the company is eventually sold or goes public. Founder two thinks about it, and realizes she is tired of long hours and little pay and was very close to founder one. She leaves too. This situation happens more often than you would think, and can be difficult for both the remaining founder(s) and investors. Let's say the one remaining founder in the example above works even harder and ultimately the company is sold five years later for $50 million. After several rounds of funding, lets say the investors own 70% of the company, the three founders together own 15% (5% each), and management and employees own the remaining 15%. The one founder still employed by the business gets $2.5 million for 6+ years of 60 to 80 hour weeks. The other two founders split the remaining $5 million, even though they spent less than a year working in the business and haven't contributed anything to the company for 5+ years, and have earned market rate salaries elsewhere for the last 5 years. Generally investors in early stage companies are making a bet on both the business and the founders/management. Once the money is in, investors are counting on the management team to take the company to a least the next set of milestones, and hopefully beyond. In the example above, not only is there a brain drain since two out of three founders leave, but since they left with all their equity it will require issuing more shares to compensate their replacements. This dilutes everyone. If there had been a vesting schedule, then each founder would have given back their unvested shares to the company when they left, which in turn could have used some of that $10 million in share value to compensate new senior managers to replace the two founders. Founder vesting agreements often contain acceleration clauses that vest some or all of a founder's remaining unvested shares in the case of involuntary termination without cause. This protects them from a predatory investor firing the founders after closing and reclaiming all the unvested equity for themselves. While acceleration can range from no acceleration to 100%, half of the

remaining shares or an additional 12 months worth of vesting is often enough to discourage termination, while still allowing the company to initiate a parting of ways with a founder if things don't work out. The company can still reclaim some shares to compensate the replacement hired and also be fair to the departed founder. Vesting is also typically accelerated upon a change in control (merger or sale). The most common method of acceleration is called a "double trigger" where any unvested shares are vested immediately if the employee in question is terminated without cause within one year after the change in control. Otherwise the shares vest as scheduled. Tax Implications In the US and other locations, income tax implications can drive a lot of the equity distribution decisions. For example, if a startup closes a round of financing that values the company at $5 million and then gives 10% of the company in stock to attract a new CEO, assuming everyone holds common stock that share grant would be taxed as ordinary income (~ 40%). Consider a simpler example. The company needs to hire a new VP of Technology. Market compensation is $100,000, but the company can only afford $50,000 per year, so they agree to pay the new VP $50k in cash and $50k in stock. Clearly the stock is compensation. The Internal Revenue Service will tax the stock grants as ordinary compensation and will expect you to pay income tax on the fair market value, $50k in this case. Thus the company unwittingly created a tax liability of $500k ($50k in the second instance), which means the new CEO would have to come up with $500k x 40% (or thereabout for ordinary income) or $200k in cash to pay the IRS. Not good. This is why founder's shares, or shares issued when the company is first incorporated, are so valuable, because they are basically worthless at inception, create no tax liability, and are subject to the much lower capital gains rate instead of ordinary income rate.

Rather than share grants, many startups and investor-backed companies will issue stock options to key employees. Stock options are the right, but not the obligation, to purchase common stock in the company at a fixed price, called the strike price. If the company is sold at a per share price that is higher than the strike price on the option, the employee can exercise the option to purchase, then sell the share, and receive the difference. The strike price for option grants are almost set at the current market price as determined by the board of directors, which means no value is conferred at the time of the grant, but rather accrues over time as the company increases its valuation. This aligns incentives, is fundamentally fair, and most importantly doesn't create a tax liability that needs to be paid in cash at the end of the year. Another, more complicated way around the tax liability is for the company to loan a key senior manager the money to purchase a number of shares at the fair market price. Because it is a purchase rather than a grant, there are no tax implications. The loan can be a simple long term (10 year) note that accrues interest, and is paid off when the there is a liquidity event. This is more complex and may no longer be acceptable in the US. Care needs to be taken that the loan and share purchase can be unwound if the employee leaves or if the company goes under, so they aren't stuck paying off the loan and the company gets some or all of its equity back. Generally, an option plan is easier to set up and administer.