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The Two Types of Equity Incentives

Startup founders often seek to bring on the best talent possible to work on their new venture. Oftentimes, the talent and work is required before the startup has a revenue stream or has raised seed funding. With those limitations, how can founders entice talented contributors to join their early-stage startup?
For startups structured as C-corporations (it is much more problematic and difficult to do if you are an LLC), the answer often comes in the form of equity incentives. By promising a stake in the startup, the employee or consultant is incentivized to join and work diligently. If the startup becomes successful, it could result in windfall for the early team members.

An Equity Incentive Plan provides for two broad categories of equity incentives:

1. Options. An option is essentially a contractual right to buy equity in a corporation over a period of time, at a pre-determined price. The holder of an option benefits from increases in the company’s valuation, but doesn’t have the rights usually associated with owning stock (i.e. voting rights, dividends, right to sue company, etc.) until after the option is exercised and equity is purchased. Terms of an option are contractually agreed upon in an Option Award Agreement. Common terms include a certain number of years of work or cooperation before options vest and the termination of non-vested options at termination of employee’s employment. This incentive is mostly effective for employees of the company only because they enjoy capital gains tax treatment instead income tax that is required to consultants or contractors.

2. Restricted Stock. Though consultants or advisors cannot fully take advantage of options and the favorable tax treatment, they can be granted restricted stock. Restricted stock includes shares that can be transferred to an individual but which must returned if service ends before the shares vest.
A team of startup founders can utilize these incentive tools to attract and retain top talent to help build a strong company and product, all of which can help to attract future funding.