This post discusses Employee Incentive Plans [EIPs] and Best Practices within those based on a questionnaire we held to extract and understand the views of our responding Founders, Investors and Policy Makers. The term EIPs covers different means that Companies can implement to involve their Teams in company goals, and covers an array of financial instruments seperate from fixed pay.
Quick Intro on Incentive Plans: Best Practices to help you Decide
In Startup Culture, EIPs are generally a means to ‘backload’ staff costs away from the precarious development phase and instead place them in a Growth or Exit phase. In exchange for the patience and risk acceptance of this ‘bait’, the backloaded ‘fish’ can be a significant upside potential.
Outside of Startup Culture too though, Incentive Plans are tried and tested methods if increasing Staff involvement and performance and to create a high performing culture with interesting perspectives. That’s why from the Legal and Consulting Industry through SaaS Companies and Med-Tech, it is a Best and Preferred Practice to implement some sort of EIP:
As Incentive Plans are inextricably linked to a Company’s Legal and Financial structure, and as their feasibility and rewardingness is heavily impacted by Taxes, we at Archipel regularly find ourselves ‘at the table’ with Companies who seek advice on how to set-up an EIP. And very often, they are convinced of the benefits of an EIP, but a little bit adrift in the options and decision points. And sometimes, this Decisions Paralysis results in great ambitions being aborted, or never even getting kickstarted at all. Don’t let the haziness win – we’ve got some insights to help you get oriented!
Where do I come in: sharing experiences to help make decisions.
A brief introduction: my name is Bas and I am a founder at Archipel. We focus on advising to Privately Owned businesses and Startups and Scaleups are at the core of that. Without exception, EIPs are av talking point at one point or another during the Startup Journey and as a result, I’ve advised on implementing quite a few.
I find this gratifying work, because [1] the broad array of possibilities makes these projects creative and academically fulfulling, but moreover [2] I think Employee Ownership is a means to creating a better entrepreneurial ecosystem, which we need for solutions to the Great Challenges of our time, and to facilitating better social mobility. So: as a true millennial, I’ve made this topic my Field of Passion in my profession, and I’ve asked my eldest daughter to comb my hair to make a good impression –>
It is in this capacity that I have asked clients and ‘friends in the industry’ to fill our a brief questionnaire to aggregate some stats on topics I often find myself having conversations around. Topics like “how much of the Company should the Team own” or “what is market practice in Leaver and Vesting clauses.” I share and contextualize these results in this post in hopes it may help you make informed decisions or find inspiration. There are statistics to be found elsewhere, like on the excellent Carta platform. However, these statistics are often ‘Anglosphere-centric’ and the results may be less representative for the Common Law space like Europe. So please consider this my ‘Small Batch overview of Best Practices’, open and for your aide and reading pleasure.
Quick Background to Employee Incentive Plans and How we Visualize Them: “The 5 Species”
Before we dive in, I share a brief primer on the topic of EIPs. Essentially, the variety of EIPs that exist is near endless, and you can easily invent a new one – intentionally or by accident. From a legal and tax perspective, however, the ‘framework & consequences’ of any EIP are established mostly through a process of ‘assimilation’; what series of existing and legally defined principles does your plan resemble most closely, and so how whould it be treated for laws and taxes?
In an effort to untangle the Plate of Spaghetti that is the acronym-filled world of EIPs, I reverse-engineer those principles to some extent in an effort to boil the vast field down to five main ‘species’ [“The 5 Types”] which can be roughly categorized under two ‘categories’:
In short, I’d say that EIPs can be categorized into [1] Cash Based Plans, which are implemented through the Employment ‘Stack’ and create upside potential that should roughly be classified as bonus pay or wage, and [2] Equity Based Plans, which are implemented through the Ownership ‘Stack’ and generally involve an equity transfer of any sort, therewith creating upside potential that should roughly be classified as share income [dividends and/or capital gains].
- Cash Based Plans:
- KPI or Individual Bonus: a ‘classic’ bonus linked to individual goals or other specified milestones;
- Virtual Stock or Company Performance bonus: a bonus plan linked to team goals or company markers like profitabiility or equity value, sometimes mimicking stock ownership;
- Equity Based Plans:
- Employee Stock Option Plans or ESOPs: a call option granted to the employee allowing them to acquire Company Stock at a certain ‘Strike Price’ upon a defined strike event;
- Depositary Stock or ‘Share Certificates’: a plan where employees obtain equity without the control rights, often implemented through the interposition of a Shareholder Trust or, bespokenly Dutch, a STAK;
- Full company Stock: the ‘holy grail’ of ownership – equity *with* control rights.
Further reading on ‘the Technicalities’ of the 5 Types:
To keep the length of this blog somewhat feasible, I do not dive into the details and workings and pro’s and cons of the 5 respective Types in more detail here, but I do highlight a range of blog posts we’ve published on specifically these topics should you want to dive in further:
I now dive deeper into some statistics we’ve been able to obtain about people’s experiences and lessons learned with EIPs.
The Incentive Plan Questionnaire
I’ve ciruclated a Questionnaire amongst several groups and platforms to obtain information, as it proved somewhat difficult to find a batch of thematically bundles stats elsewhere. Now my N at the moment of writing this is no ‘superlarge’ with 47 respondents, I do feel that the respondents represent a much larger experience group as the group consists of Founders, VC-Folks and other Investors, and a handful of Policy Makers. Therefore, I think the data is valuable and representative.
And if you would like to add your experience to my database, please do so in exchange for Kudos and my gratitude: https://form.jotform.com/241830689321054
Topic 1: Cash or Equity?
The goal of any EIP should be to align the Team’s interests with that of the Company itself and its investors, by interlinking their financial fates. If set up effectively, having any incentive plan in place should therefore already make a noticeable difference, as studies show. But let’s try to naarow down the first A/B-choice: Cash or Equity-based plans?
In general, which type of Incentive Plan do you think encourages achieving Company Goals best?
The first question of our questionnaires explores what type of EIP our respondents believe encourages pursuing and achieving Company Goals best. Cash-based plans alone get a relatively low score with 7% of the vote. Equity-based plans alone do three times better but notably, a mixed plan takes the prize with 72% of the vote.
This can make sense, as Equity-based Incentive Plans tend to generate returns relatively late in a Company cycle as they require either distributable dividends or an Exit or Sale to do so. Cash-based plans, on the other hand, are part of the Company’s cost base and Bonus Potential can also come to fruition based on other markers, like hitting speficic milestones linked to other markers than profitability or Equity transfers, like PRLs or Sales Targets instead. However, Cash-based plans can lack the ‘psychology of ownership’ and therefore be relatively uncommitting alone.
And, in general, which type of Incentive Plan do you think is most ‘Investable’ of preferable for Investors?
Second, we asked whether working with Cash or Equity would look better in the eye of an Investor. Interestingly enough, the outcome here is vastly different:
Cash-based plans were most often seen as the most ‘Investable’ or at least most preferred by investors. A reason could be that Cash-based plans do not interfere with Company control, and that Cash-based plans are implemented through the Employment ‘stack’ making an untangling feel more feasible in case of, for instance, termination or other ‘bad cases’. However, they did not take the majority and most notions of a ‘Most Investable’ setup did include Equity. This, in turn, can be because of the long-term element to it, making sure that Key People ‘stick’ post through any rought patch or Change of Control.
Topic 2: Experience Check on a Deeper Level – Incidence and Value for Staff and Company of the ‘5 Types’
An often-heard ‘Rule of Thumb’ is that Cash-based plans are better from a Company perspective, but Equity-based plans are better for Employees. The idea that Cash is better for Company exists mainly because Cash-based plans are more flexible in their implementation than Equity Agreements, which subjected to a much thicker regulatory framework. The idea that Equity favors the Employee, on the other hand, stems from that same distintion, and the notion that this ‘separate relationship’ gives the Employee more security while Equity returns are also generally more favorably taxed.
Some strawman counter arguments could be that Equity ownership is more complex and can come with downside risks upfront, like buy-in amounts or purchase price loans which, and risks ‘at the back’ like Bad Leaver situations or adverse tax workings. At the same time, Equity could actually be more favorable for Investors as they naturally only generate returns when the company does well, while its long-term effects encourage involvement and ‘taking ownership’.
In order to decide by committee, we asked three experience-based questions about the 5 Types with multiple answers possible, and we will zoom in per question after the agggregated visual:
- Which of these 5 types do you have experience with in any capacity? (Light Blue)
- Which of them do you think, all things considered, is ‘simply the best’ for the Team? (Purple)
- And for Company / Investors? (Dark Blue)
Which of the 5 Types do you have live experience with, either as Staff/Beneficiary of as Company/Founder/Investor?
The most prevalent type of EIP, unsurprisingly, is the ‘traditional’ KPI Bonus (Individual Bonus). Next in line was traditional Equity Ownership, but do note that these statistics can be skewed as the group of respondents included an outsized amount of Founders.
Perhaps the most remarkable statistic here is the prevalence of Depositary Stock, which is a relatively complex setup in which the Company Shares are owned by a Foundation or Trust [‘STAK’ as a Dutch acronym for Share Administration Foundation] whose board, often consisting of the Company’s Founders and/or Investors, exercises the related meeting and voting rights, while the rights to the Shares’ economic fruits are owned 1:1 by the owners Team Members who own the ‘Depositary Stock’ also known als Share Certificates.
Also: we note how often talked about Stock Options are [often called ESOPs] while their incidence is relatively low. This can be explained by the different general tax treatment in continental systems, where the conversion benefit [the amount that the Option is ‘in the money for’ when it is called] is treated as wage in kind rather than a capital gain.
Which of the 5 Types do you think is -generally speaking- ‘Simply the Best’ for Staff/Beneficiaries?
When asked which of the 5 Types of EIPs they believe is best for the participating Team members, the responnses are pretty evenly spread. The variety making the most significant leap compared to its experience stat is the Virtual Stock Plan. Such plans are essentially Bonus Plans but their potential [money amount] and trigger [pay-out event] are linked to Company-wide markers as opposed to individual ones. Often times, such markers can be Company profitability or Equity Value, perhaps established based on a Priced Round [Investment] which can equally be the trigger event for the Bonus becoming payable.
And for Company/Investors?
Interestingly, the ideas about which of the 5 Types would be best for investors are not significantly different from those about which would favor the Team. It may be somewhat significant though that Equity Ownership is more often mentioned as Investor-favorable than participant-favorable. Perhaps this is our Founder-heavy crew of respondents’ way of warning that being an Owner is not just Blue Skies!
Topic 3: Let’s talk Percentages – How should you want your pie to be sliced?
Next we wanted to get concrete. If you’re going to implement an Incentive Plan, who should own what? Before we proceed, we note that it is ‘standard practice’ [from a VC perspective at least, so we understand] to consider beneficiaries of Cash-based plans [especially Virtual Stock or Stock Appreciation Rights] as being ‘on the cap table’ as well. For the sake of simplicity, we refer to such involvement as Ownership too, despite being involved with an Equity-linked Bonus Potential does not officially comprise ownership from a tax or legal perspective.
What percentage do you believe Innovative & Growth Companies should target Staff to be ‘on the cap table’ for [in any which way] come an Exit?
In this context, the respondents provied the input as shown below, which is somewhat challenging to read. For context, an often-heard rule of thumb is ‘VC wants the Team to be in for about 10%’. On the one hand, the most voted-for option was that Staff should be ‘on the Cap Table’ for at most 5%. On the other, roughly 60% of the votes went to a stake in excess of 5% and roughly half even went for more than 10%, with a notable 36% even voting for more than 20%.
Perhaps the best way of reading this, however, is to ‘go big or go home’. Through the questionnaire, it was never asked whether the respondents believed in an EIP at all, and perhaps this was the one opportunity to vote ‘no’ or ‘hardly so’. For those who do believe in it, however, the message seems to be: make it dramatic. If you’re gonna go for a broadly based ownership plan as an outing of ‘Shared Capitalism’, dillute with confidence and make it spectacular!
And how much should the Founding Team own around then?
Intertwined with how much the Team should own, however, is also how much the Founding or Managing Team *can* own, especially when there should be room for investors too. The vote is pretty even across the board here too, with the option most voted for being 25% – 50% for the Founders. However, over 60% of the votes involved a setup where the Founders have some sort of a majority, either through absolute Equity [>50% ownership] of through a Legal Arrangement [Voting Mechanism] that at least allows them to retain ‘control’ of the Company:
Whatever you choose, we do advice to involve a Company Lawyer to help fully grasp your options and their consequences. The odds of dropping below majority control increases with each Round and many of the most scaled companies are not majority-owned by their Founders. However, dropping below the threshold is not easily reversed, so make sure that the ‘Control Team’ consists of value-adding individuals when you dillute.
Topic 4: the Way in – how should access to the EIP work?
Once you establish the main characteristics of your plan, like what Type suits you best and what percentages will you target, the more detailed elements of the plan must be addressed.
Skin in the Game?
The first question we asked was about ‘Skin in the Game’: do you think that a financial Downside Risk like an upfront investment or a Share Purchase Loan [‘Skin in the Game’ / a potential for losing money in downside or leaver scenarios] makes EIPs more efficient? As per our respondents:
Interestingly, a significant majority believes that EIPs work better if there is not only an upside potential, but also a downside risk; a potential for the Team Member to lose money or potential if the Company underperforms and/or their involvement ends, for instance in case of a ‘Bad Leaver’ scenario. And perhaps there’s truth to that; an Incentive Plan that has only upsides does not align the interests of the Company and its Team as there is a one-sided assumption of risks. At the same time, it seems only fair that some Risk also comes with some sort of influence to manage it, so whichever plan requires a Buy-in may also need to come with certain privileges for the investing Beneficiaries.
How big a Downside Risk?
If we assume that a Downside Risk should be part of the Entry Ticket to the EIP, the question arises how big an exposure is fair and effective. Of course, this is influenced by how much of the ownership the Company is willing to place with the Team (and vice-versa), and different seniority levels may also justify different investment levels. Taking into account such considerations and thinking ‘in general’, the respondents voted as follows:
The option taking most the votes is a Downside Risk [e.g.: a Buy-in or Purchase Price Loan] equal to 3 to 6 months’ pay. It seems only logical that for Management Buy-ins, the exposure could be much more significant whereas it could be much more limited for entry-level candidates in very broad based EIPs.
And how Significant an Upside Potential?
Another metric to think about, is how big the Upside Potential should be. Of course, the Downside Risk and Upside Potential influence each other and should be balanced to create a plan worth setting up. But to be effective, how spectacular should any backloaded and success-linked payout potential be? The respondents voted as follows:
The option taking the most votes is over 1 Annual Salary, which even accounts for two thirds of the votes when combined with the next best-voted option of the Life Changing Event [which, for the avoidance of doubt, is implied to be over 1 years’ pay]. Do note that this Upside Potential doesn’t necessarily have to materialize at once; any EIP may also generate compounded benefits that add up to the stated amounts. Either way, though, the respondents are clear: bigger appears to be better when it comes to the rewards of Incentive Plans.
Optional or Standard Participation?
When such perks but also risks are involved, the question is whether the EIP should be ‘standard’ and inevitable [i.e.: ‘part of the job’] or whether it should be an election-based ordeal that Team members can opt-in for. As per the respondents:
A significant majority thinks it is best for the Team to have a choice in the matter. On the one hand, this can prevent more risk averse talents from avoiding the Company, as well as people who simply cannot afford to participate for whichever reason. On the other, leaving the option open can create ‘haves and have-nots’ within the same company [the haves being the opted-in in upside scenarios and the opted-out in downside ones] which can lead to tensions, whilst any sense of having ‘missed the boat’ can equally lead to regret or resentment. All in all, however, the respondents are clear: give the people a choice in the matter. Especially if there are Downside Risks involved, I add.
Topic 5: Common Clauses and the Implementation Process
Next up are common clauses.
Which Vesting Scheme do you think Works best?
EIPs often involve a ‘Vesting Scheme’, which basically refers to a mechanism that increasingly ‘toggles on’ the allocated Incentive potential as certain milestones are hit, most often simply linked to tenure. As clauses like these are often difficult to benchmark, I compiled four varieties that I’ve encountered on more than one occasion. Presented with the choice, the respondents voted as follows:
The variety that takes most the votes is a Vesting Scheme that involves a 1 year ‘Cliff’ [i.e.: a period during which no units Vest yet] after which a 4-year evenly incrementing Vesting scheme is triggered as a result of which the EIP is ‘fully vested’ after a 5-year tenure with the Company is completed from the signatory date. The ‘Accelerated Vesting’ clause means that any otherwise unvested rights vest immediately if an Exit takes place before full vesting, allowing the beneficiary to participate with thei full potential if an external buyer shows up quicker than expected.
As Tax Guys, we do want to highlight that Vesting Schemes can create incremental ownership transfers too, as unvested shares can sometimes hold no economic rights. This can be avoided with a Reverse Vesting scheme under which all the rights are Vested upfront, but a clawback clause takes them back to the Company at €0 in case of any unintended Leaver Event. Such technicalities aside though, the message is clear: you’re generally best off implementing some sort of a Vesting Scheme.
Should Team members get to keep their Vested Units after Leaving?
Another topic os whether Team members who leave the Company get to keep their vested rights. On the one hand, this may create what’s known as ‘Dead Equity’, ultimately providing the active employees with less ‘throttle feel’ on their efforts as their relative weight on the Cap Table decreases. On the other hand, allowing Leavers to keep their Vested units may create ambassadors to the firm, and may also prevent underperforming of overcomplete Team members from ‘clinging on’ to they position at the Company in order to avoid the evaporation of their built-up rights. The respondents voted as follows:
The ‘prevent dead equity’-team wins this one by a slim margin. We should stress, however, that even for camp ‘Yes’, we imply or expectd that a ‘Bad Leaver’-event [i.e.: a situation in which a Team member leaves the Company in bad standing] would always lead to Vested rights being forfeited. Note that this item is very much linked to Company Culture and, in a sense, a matter of principle.
Where would you focus your time?
We wanted to get a grasp for which of the ‘Usual Clauses’ deserves -or requires- the most attention. We discriminate between:
- The Subscription Clause, which deals with the quantity and value of the Units that will be allocated and how they should be acquired and, perhaps, paid for;
- The Vesting Clause, which deals with the Vesting Scheme as discussed above, and;
- The Leaver Clause, which sets the framework for what happens when people leave the Company before any Exit event, in good, regular or bad standing respectively.
When asked which clause they would accepts a Boiler Plate for and which they would put the time into assuming there were constraints and they could pick only one, the respondents voted as follows:
The message here seems to be that that the Leaver Clause is the most important one to tailor-make. Perhaps understandably so: when implementing a plan, the driver is often a big vision underpinned by a harmonious and high performing team. But Team members can shift away for any number of reasons and absent specific wording to the contrary, they remain entitled to their Vested rights. Dealing with this properly and upfront may seem confrontational and distrusting, but it can prevent lengthy and furstrating procedures in already unwanted situations, and avoid demotivating scenario’s for persistently high-performing Team members watching from the sidelines.
And at a higher level, which is more important: simplicity or efficiency?
Finally, we asked which is more important provied they are mutually exclusive yet perfectly balanced: the EIP’s Simplicity or its Efficiency. With Simplicity, we mean ease of admin and understanding. The fewer variables and documents involved, the more simple the plan is. Studies show that how well a plan is understood heavily impacts how well it works, so this factor seems important.
The plan’s Efficiency means how significant the upside potenntial is and, importantly, how favorably taxed is. Once a significant upside arises, an equally significant tax charge can take away much of the sweet taste, and knowing that the tax is suboptimal beforehand can make the plan less motivating. When asked which is more important, the respondents voted as follows:
It appears there is a willingness to sacrifice certain simplicity for more efficiency given the choice in a perfectly balanced world. And perhaps the closing remark, then, is to make sure you get a good Tax Advisor involved 🙂
Speaking of which:
Want to talk about what may work for you? Book a slot in my Calendly – it’s on the house and I enjoy this stuff!
Feel free – and send me some bullets or documents ahead if you want to go a bit in-depth. All yours, curious to see what we may discuss!
