This Memorandum is subject to further review and update as circumstances develop and should not be relied on for any legal advice without consultation with an attorney.
In this article, we will give you an overview of several types of equity and highlight common considerations when issuing each type. Please note that, in this article, we will focus on corporations. Limited liability companies (“LLCs”) have different types of equity for members, investors, and service providers.
The type of equity that is most appropriate for a company will depend on its stage of development, its financial situation, and its goals. To start distinguishing between types of equity instruments, it is helpful to begin by thinking about who the recipient of the equity will be, although certain types of equity, like shares of stock, can be issued to multiple kinds of recipients.
In this article, we’ll distinguish between two groups:
· Founders, Employees & Other Service Providers
· Investors & Partners
Founders, Employees & Other Service Providers
Here, we are thinking about people who are receiving equity in exchange for services (e.g., founders, employees, independent contractors, advisors) in lieu of, or in addition to, cash compensation. In the case of founders, they might also be contributing intellectual property to the company in exchange for equity. For cash-strapped start-ups, equity compensation can help you attract and retain top talent, as well as align the interests of the service provider with those of the company. Equity compensation can provide incentives for service providers to hit certain achievement milestones or stay with the company for a period of time to ensure their equity vests.
The most common types of equity include:
· Common Stock: Common stock is the most basic form of equity. It gives shareholders the right to vote on company matters and to receive dividends, if any are declared. It is commonly issued to founders when the company is first formed (sometimes colloquially referred to as “Founder’s Stock”). The stock mayor may not be subject to vesting, which would incentivize the founder to continue providing services to the company. There will be tax implications for a service provider when they are issued stock, so it is important to consult an attorney and/or tax advisor at that time.
· Stock Options: Options are another very common type of equity which give the holder the “option” to purchase common stock at a certain price (the “exercise price” or “strike price”) at a time in the future once the option has vested. Options are usually subject to a vesting schedule (i.e., monthly over four years) and cannot be exercised until the options have vested. Once an option is exercised, the holder becomes a stockholder and, only then, will the holder of the option receive the rights of a stockholder (e.g., the right to vote on company matters). One benefit of options is that there is nota taxable event until the shares are exercised (and in some cases, not until the shares are ultimately sold), so it simplifies the equity issuance in the short term for the service provider. To issue options, a company will usually put an equity incentive plan into place first which, among other things, reserves a pool of shares of stock(an “Option Pool”) specifically for issuance to service providers in exchange for services.
· Restricted Stock (aka “Restricted Stock Awards”): Restricted stock is essentially common stock that is subject to vesting and certain other restrictions. Colloquially, restricted stock often refers to common shares that come out of the Option Pool, whereas Common Stock or Founder’s Stock would have been issued prior to the creation of the Equity Incentive Plan. This can have implications for dilution and the securities law analysis, but, other than that, Common Stock, Founder’s Stock, and Restricted Stock are identical.
· Restricted Stock Units (“RSUs”):RSUs give the holder the right to receive a specified number of shares of stock at a later date and can be issued outside of an equity incentive plan. Similar to options, no shares of stock are actually issued at the time of grant. In contrast to options, no purchase price is specified at the time of grant for RSUs. But like shares of stock and stock options, RSUs can also be subject to vesting. RSUs are much less common than options in early-stage companies.
· Phantom Stock: Phantom stock is also uncommon in early-stage corporations. Phantom Stock operates very much like an RSU, except that it gives the service provider the right to receive payments in cash instead of issuance of actual shares.
· Stock Appreciation Rights (“SARs”): SARs are similar to phantom stock, but they give service providers the right to receive payments that are based on the increase in the value of the company’s stock. Like RSUs and Phantom Stock, SARs are uncommon in early-stage corporations.
Investors & Partners
Here, we are thinking about investors, who are making a cash investment in exchange for equity to help the company grow, and partners, who may be receiving equity as part of a commercial arrangement. The most common types of equity and convertible securities granted to these recipients include:
· Simple Agreement for Future Equity (“SAFE”): Originally coined by Y Combinator, the term “SAFE” refers to a short agreement that gives the investor the right to convert their investment amount into preferred stock at a future equity financing. Although there are a few terms to negotiate (e.g., valuation cap, discount), the primary benefit of SAFEs is that they are simple, standard form documents that companies do not have to spend much time and money negotiating. The SAFEs will not appear on the cap table until they convert into shares of preferred stock, but should be tracked on a ledger attached to the cap table. Once a company has negotiated the primary terms of a preferred financing the number of shares of preferred stock into which the SAFEs will convert can be calculated. You can find the standard form of Y Combinator SAFE here.
· Convertible Promissory Note (“Notes”): Like SAFEs, Notes are intended to convert into preferred stock at a future equity financing and will not immediately appear on the cap table, but should be tracked on a ledger attached to the cap table. Notes differ from SAFEs, because they have some debt-like features (e.g., maturity date, interest rate). Because of their relative complexity, Notes do require more negotiation than SAFEs. However, compared to a preferred stock financing, a convertible note financing can likely be completed more quickly and accomplished more efficiently. Convertible note financings are sometimes referred to as “bridge financings,” because they are intended to help a company raise enough capital to get them to their first (or next) priced round.
· Preferred Stock: Preferred stock (i.e., Series A, Series B, etc.) provides the holder with certain rights and preferences that the common stockholders do not have (e.g., the right to be paid out first in the event of a liquidation event, or approval rights over certain company actions). These terms will be negotiated with an investors and captured in a term sheet. You can find the standard National Venture Capital Association Term Sheet here. We recommend engaging counsel prior to signing a term sheet and you will certainly need legal support to draft the agreements and close the financing. A preferred financing round is complicated and involves numerous documents and coordination with the lead investor’s counsel and the other investors.
· Warrant: Warrants are similar to options in that they also give the holder the right to purchase common stock at a certain price (the “exercise price” or “strike price”) within a certain period. The main difference is that options are typically issued to service providers and warrants are typically issued to third parties (e.g., a bank providing a debt facility or a commercial partner). Warrants can be an added benefit offered to a counterparty to sweeten a deal. As it the case with options, they also align incentives between the parties. If everyone cooperates, the value of the company will go up, which will benefit all equity holders.
· Common Stock: Common Stock is less likely to be issued to investors, although convertible notes may contain the right for the investor to convert to common. Common stock may be issued to partners as part of a commercial arrangement. It is common, for example, to see universities receive common stock when start-ups spin out from the institution and negotiate a license for intellectual property owned by the university.
It’s important to remember that any type of equity issuance will implicate both federal and state securities laws (also known as “blue sky laws”) that regulate the offer and sale of securities. Given the type of offering, the requirements vary federally and from state to state. All equity issuances, regardless of type, require adherence to various corporate formalities (e.g., board approval or setting up an equity incentive plan). Accordingly, we recommend consulting with an attorney before issuing any securities. As Benjamin Franklin wisely noted, an ounce of prevention is worth a pound of cure. Please feel free to reach out to anyone on the Feinberg Hanson team if you would like to discuss the issuance of equity securities or the corporate formation of your company.