Startup companies are growth-based. This means that their revenue model depends upon achieving rapid and sustained growth until the company reaches maturity. At the point of maturity, the company either sells to a strategic investor or goes through a public offering.
During the company’s rapid growth stages, it generally receives equity funding from investors to fund operations. It is somewhat rare for a startup to be able to fund its operations in a way that meets its growth potential without seeking outside capital. Investors generally require that the company set aside a certain quantity (generally 20%) of the company’s equity to compensate employees of the company. This percentage of equity is known as an “option pool”. The idea is that loyal and dedicated employees are more productive for the company. The way to make the employee loyal and dedicated is to provide them an ownership interest in the company.
As such, key employees of the company often receive equity as part of their compensation plans. The type of equity received with either be common shares, restricted stock, stock options, preferred shares, or some other equity equivalent (such as phantom shares or profits interests).
This article addresses the question of what percentage of the company equity does a general counsel own prior to an initial public offering (IPO).
General Counsel Holds Stock Options
Let’s begin by discussing how a general counsel might come to hold stock options in a company. Most companies do not bring on a general counsel early in the startup’s lifecycle. The exception to this rule is when the company operates in highly-regulated or transaction-heavy industries. In this case, a general counsel may be an early employee of the company. The reason this is important is because it affects the company’s ability to adequately compensate the general counsel. The general counsel position is generally a somewhat highly compensated position. The startup may be able to provide an adequate salary early on. Further, it may be too risky for the counsel to join the startup based upon the high percentage of startups that fail. As such, the startup will generally have to use company equity to supplement the counsel’s monetary compensation. This also serves to create long-term loyalty to the company.
Company IPOs generally take place at a later stage of company development — generally very close to maturity. The earlier the general counsel becomes a part of the company, the greater the percentage of equity she will own prior to the IPO. It is important to note, however, that the equity received by the general counsel early in the company’s life will be diluted with every consecutive round of investor financing. This is because the company is issuing additional stock in each financing round. Investors are paying the value for the stock, so the value of the counsel’s holdings should remain the same. Her percentage of ownership, however, will be reduced accordingly.
If the counsel joins the company at a later stage of development, the company may be able to afford a higher salary for the counsel. Still, the company will likely offer stock or stock options to the counsel to incentivize her continued service and loyalty. Stock options are generally used at these later stages. They award the general counsel the ability to purchase stock at a given price. The counsel does not actually become an equity owner at the time of award. She must exercise the stock option to take advantage of the benefit. The option only has value when the company grows in value after the option is granted.
All of these factors will affect the determination of how much equity or options a general counsel will hold prior to an IPO. This will be a subjective determination for the specific counsel at a specific company. Unless the counsel is a co-founder or very early-stage employee, it would be rare for a counsel to hold even 5% of the outstanding equity. This is primarily because of dilution and her secondary role to that of the founding members. A more common occurrence may be for the counsel to hold .5 – 1% of outstanding equity.
If your startup is considering issuing equity to members of its team, you should understand how to use equity to incentivize your employees. If you are seeking a general counsel position with the company, you should know what to expect with regard to equity compensation. The legal and business attorneys at LawTrades can provide you all of the advice and guidance necessary to navigate this process.