Most startups have limited capital but must compete with large corporate salaries to retain talent. Instead, they can give employees equity as compensation without stretching the company budget. Understanding how to handle employee equity compensation and protect your company’s ownership is essential.
If managing equity compensation gets complicated, look for a UK startup accounting firm for expertise. This guide will cover almost everything you need about equity compensation in startup accounting.
Table of contents
● What is equity compensation?
● Why give equity compensation to employees?
● How does startup equity work?
● What tax benefits do you get with equity compensation?
● How much should company equity be reserved for employees?
What is equity compensation?
Equity compensation is an employee perk that provides partial ownership in your startup company after you meet the internal vesting needs.
What is equity? It is the amount of money each shareholder gets when company assets are liquidated, and debts are paid off. If you have equity in a company, you hold a percentage of ownership. It is usually divided among company founders, investors, employees, and advisors.
Initially, the founders hold 100% equity in a company. If there are multiple founders, this percentage gets split among them; a part of the equity is later given to investors in exchange for funds. After that, you can offer equity compensation to employees and advisors.
Why give equity compensation to employees?
Equity-based compensations are beneficial to both employer and the employee. It allows employers to make their staff happy without compromising the budget, and employees appreciate it.
Not only early-stage startups but several others offer equity and high salaries to retain their best employees and make them feel attached to the company.
Equity compensation is a great motivator, as employees can earn a large sum of money by selling these valuable shares after a few years.
Here are a few reasons why to give equity to employees as compensation:
● Employees remain aligned with organisation goals
● It promotes employees’ long-term commitment
● It enhances team cohesion and company culture
● Attracts top talents in the market
● Schemes like EMI offers employees and employer a special tax benefit
● You are getting exposed, commitment, and opportunity to attain success faster in exchange for equity
How does startup equity work?
When granting employees a part of your ownership, you must consider three critical areas to determine how equity compensation works for your company and how much you can offer.
1. Shares or options
One of the best ways to offer equity compensation to employees is through options. When someone buys shares in a company, they immediately become a shareholder.
On the other hand, granting equity through options gives employees the right to buy shares in the future. It means the rights associated with the shares are accessible only when the employee buys them.
2. Decide the option pool size
Option pool refers to the amount of equity kept aside for employee options in the business. The decision on how many options to allot each employee will depend on the total size of your option pool.
3. Choose the right scheme
There are different types of HMRC-approved options schemes in the UK that you can use or design your own scheme. For that, you need to consider the company size and stage, cash flow, company culture, and type of incentive package you want to provide.
However, EMI (Enterprise Management Incentive) is the most popular option scheme.
What tax benefits do you get with equity compensation?
In the UK, companies with assets of £30 million or less offering equity compensation come under the Enterprise Management Incentive (EMI) scheme, where both parties receive a tax benefit.
They can grant employees a share of £250,000 in three years. However, companies that work in “excluded activities” cannot offer EMIs. The excluded activities are banking, farming, property development, provision of legal services, and shipbuilding.
What is the tax benefit?
● No income tax and National Insurance contributions
● Receives a corporation tax relief on the difference between the market value of an equity share when purchased and the final price paid by the employee
● Minimum tax costs in comparison to cash and other remunerations
● No income tax or National Insurance contributions for employees taking part in the EMI scheme
● They pay a reduced capital gains tax on the long-term value growth of the equity shares. It is carried out through tax credits and other tax relief methods under the scheme.
You must share the details with your self-assessment tax return and always update your books to ensure you stay on top of accounting.
How much should company equity be reserved for employees?
The company equity you want to offer your employees depends on the size of your option pool or the Employee Stock Ownership Plan (ESOP).
Researchers say nearly 48% of the UK startups set aside 5 to 20% of their equity shares at funding rounds to the option pool, which later rose to 10-11% in the later funding rounds.
According to financial experts, companies raising early-stage funding between £200k and £3 million can put aside 10% of their overall company equity for the option pool. However, this amount will likely grow as the company progresses through the following funding rounds.
● For the first employees (up to 10) during the early stage: Give 1% of the overall company equity to each employee.
● For midsize companies with employees (15-50): Give equity shares depending on seniority or performance
● For growth stage businesses with employees (50+): Follow a scheme and allot options depending on employee role and seniority or a multiple of employee salary.
If you are compensating based on seniority, you must focus on a few things,
● Amount of equity available in the employee option pool
● Employee’s value in the company
● The perfect amount that can incentivise employees and retain them in business
Various factors can affect equity compensation to employees in a business. It further leaves a mark on your accounting sheets. If you don’t understand the cash flow in business or have a budget, you may end up giving all your company shares. It is advisable to ask a startup accountant before putting your equity at risk.