How Employee Equity Can Impact Small Business Financing

Are you considering offering your employees equity in addition to their typical salary or wages? For many small business owners, doing so is an effective way to attract top talent and increase employee engagement – which is more important than ever post-pandemic. However, it’s important to consider how it may impact your company’s borrowing power. Here’s a closer look at employee equity, how it works, and how it can impact the financial future of your small business.

What is Employee Equity in a Small Business?

When small business owners offer employee equity as part of their compensation package, employees receive company stock (or stock options). As a result, they become collaborative employee-owners with a personal stake in company performance. This can be an enticing benefit plan that helps business owners attract and retain talent, especially early-stage startups poised for growth.

How Employee Equity Works for Small Businesses and Startups

Before a small business offers employee equity, it will need to decide on a few factors. For example, ownership options, vesting periods, and ownership structures.

Employee Equity Types

The common ownership options offered by employers include:

• Stock Options: An option for employees to buy or sell a certain amount of shares from the founders at a predetermined price during a specified period. The options may come in the form of Incentive Stock Options (ISOs) or Non-Qualified Stock Options (see FAQs at the end to learn more).
• Stock Grants/Restricted Stock: A defined amount of stock given to the employees.
• Stock Warrants/ Employee Stock Purchase Plans: An option for employees to buy or sell a certain amount of shares from the company at a predetermined price during a specified period (often longer than is allowed with stock options).

Startups tend to opt for stock options for new employees, while stock grants are often given to seasoned executives. When stock warrants are offered, they’re typically an option given to all types of employees within an organization.

Vesting Periods

Employees don’t typically receive all of their stock option or warrant benefits on the first day of their employment — that would pose too much risk to the companies. Instead, the equity is often given over a timeframe that includes holding and vesting periods.

In many cases, startups require an employee to work for the company for a certain amount of time before the vesting schedule begins. That period often lasts one year and is known as the holding period. Afterward, the employee will begin earning their equity.

A common vesting schedule for employee stock options is spread out over four years, where the employee gets a portion of their equity each year. The equity disbursement may be equal over the schedule or may vary (e.g. increasing each year).

Overall, this incentivizes employees to stay with the company, at least until they’ve earned all of their stock benefits, but likely longer so they can reap the benefits of the company’s growth.

Stock Allotment

Another key step is deciding which employees will get equity, along with the type and amount they will get. For example, employees may get more employee stock options if they join the company earlier, or may get a larger share of the company through stock grants based on the seniority of their position. All of the company’s shareholders, their equity shares, and the total amount of equity should be documented in the company’s cap table.

How Equity Impacts Lending Decisions

According to Eqvista, an equity management software company, startups typically set aside from 10% to 25% of a company’s shares for employee equity programs. However, larger shares may be disbursed for founders, co-founders, key stakeholders, investors, etc.

One thing to consider when deciding how much of a company’s shares you will allot to a person is how it will impact your ability to gain financing. For example, the U.S. Small Business Administration (SBA) requires a personal guarantee from each individual that holds at least 20% of a company’s equity.

That means that shareholders with 20% equity or more would need to get approved for an SBA loan based on their personal credit status. If their personal credit is less than satisfactory, it can prevent your business from being able to borrow funds.

Getting Business Credit With an Employee Equity Plan

While the SBA and many other private lenders require personal guarantees from creditworthy stakeholders before they’ll issue business loans, there are alternative lenders that won’t factor personal credit into their decision-making process. Instead, they make a decision solely based on your business credit. As a result, by building your business credit score, you can ensure you’ll have financing options regardless of your company’s employee equity plan or who is holding large amounts of your company’s equity.

FAQs About Employee Equity

Still have questions about employee equity? Here are the answers to some frequently asked questions.

What is an employee ownership trust (EOT)?

An EOT is a trust that holds a long-term or permanent stake in a company and aims to operate in the best interest of the employees. It provides employees with an indirect form of ownership and typically reserves a portion of annual profits to a profit-sharing pool for employees.

What is an employee stock ownership plan (ESOP)?

An ESOP is an employee benefit plan that functions as a retirement plan. It involves a company setting up an ESOP trust and issuing shares to employees relative to their pay. As employees work for a longer period, they gain increased rights to the shares. Upon retirement, the company buys back the retiree’s shares at fair market value.

According to The National Center for Employee Ownership (NCEO), the benefits of employee ownership range from attracting and retaining employees to tax benefits to enabling the buy-out of an owner by employees.

What’s the difference between Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NSOs)?

ISOs are stock options that are reserved for employees. They are only taxed when sold and the tax rate depends on when the sale happens. If sold before a collective three-year period (one year for holding, plus a two-year vesting period), the profits will be taxed using the regular income tax rate. Afterward, the profits will be taxed according to the capital gains rate.

On the other hand, NSOs can be given to anyone, including employees, and are taxed at normal income tax rates. They don’t have holding period limitations and are often given to third parties like consultants, advisors, or members of the board of directors.

Interested in learning more about business credit so you can protect your company’s ability to access financing without personal guarantees? Tillful’s business credit score gives you an accurate view of your company’s financial health and matches you with curated funding offers.