Why Equity in Offer Letters Needs Special Attention
Equity compensation is one of the most complex elements of an offer letter. Unlike cash compensation, where the terms are straightforward, equity involves multiple variables — type of equity, vesting schedules, exercise prices, tax implications, and governing plan documents. Presenting equity clearly in the offer letter is essential for attracting candidates and avoiding disputes.
The challenge is balancing completeness with clarity. You need to include enough detail for the candidate to understand and evaluate the equity offer, but the full terms are governed by separate plan documents and grant agreements that should not be reproduced in the offer letter.
Types of Equity Compensation
Stock Options
Stock options give the employee the right to purchase company shares at a predetermined price (the exercise or strike price) after the options vest. There are two main types:
Incentive Stock Options (ISOs) — Available only to employees (not contractors or board members). ISOs receive favorable tax treatment: no ordinary income tax is owed when the options are exercised, and gains may qualify for long-term capital gains rates if certain holding period requirements are met.
Non-Qualified Stock Options (NSOs) — Available to employees, contractors, board members, and others. NSOs are taxed as ordinary income on the difference between the exercise price and the fair market value at the time of exercise.
Restricted Stock Units (RSUs)
RSUs are a promise to deliver shares (or cash equivalent) upon vesting. Unlike stock options, RSUs do not require the employee to purchase shares. They have value as long as the company stock has value, making them less risky than options from the employee's perspective.
Restricted Stock Awards (RSAs)
RSAs involve issuing actual shares to the employee at the time of the grant, subject to vesting restrictions. The employee owns the shares immediately but may have to forfeit unvested shares if they leave the company. RSAs are most common at early-stage startups.
The type of equity you offer depends on your company's stage, structure, and tax considerations. ISOs are most common at startups, RSUs are standard at public companies and later-stage private companies, and RSAs are typical for very early employees or founders.
What to Include in the Offer Letter
Grant Size
State the number of shares or units being offered. Be specific:
"Subject to board approval, you will be granted an option to purchase 25,000 shares of the company's common stock."
Avoid stating equity as a percentage of the company unless you also provide the fully diluted share count. Percentages without context are misleading because they change with future financing rounds and equity grants.
Type of Grant
Specify whether the grant is ISOs, NSOs, RSUs, or RSAs. This matters for tax planning, and candidates deserve to know upfront.
Exercise Price (for Stock Options)
For stock options, note how the exercise price will be determined:
"The exercise price per share will be equal to the fair market value of the company's common stock on the date of grant, as determined by the company's most recent 409A valuation."
Do not state a specific exercise price in the offer letter unless the 409A valuation is current and the board has already approved the grant. Exercise prices can change between the time the offer letter is sent and the time the board formally approves the grant.
Vesting Schedule
The vesting schedule is critical and should be stated explicitly. The most common schedule for startup employees is:
Four-year vest with a one-year cliff: No shares vest during the first 12 months. At the one-year anniversary, 25% of the shares vest. The remaining 75% vest in equal monthly or quarterly installments over the next 36 months.
Include:
- Total vesting period
- Cliff period and percentage
- Post-cliff vesting frequency (monthly, quarterly, annually)
- Vesting start date (typically the start date of employment or the grant date)
Make sure the vesting start date is clearly defined. Ambiguity about whether vesting begins on the hire date, the grant date, or the board approval date leads to disputes. Best practice is to tie vesting to the employee's start date.
Acceleration Provisions
If the equity grant includes acceleration provisions, describe them:
Single-trigger acceleration — Vesting accelerates upon a single event, usually a change of control (acquisition or merger). This is more employee-friendly and less common.
Double-trigger acceleration — Vesting accelerates only if two events occur: a change of control and the employee's termination (either involuntary or for "good reason") within a specified period after the change of control. This is the more common approach.
If no acceleration provisions exist, it is acceptable to omit them from the offer letter, but the candidate may ask.
Post-Termination Exercise Period
For stock options, specify how long the employee has to exercise vested options after leaving the company. The standard period is 90 days, but this is an increasingly negotiated term. Some companies now offer extended exercise windows of one to ten years.
Board Approval
Always condition the equity grant on board approval:
"This equity grant is subject to approval by the company's Board of Directors and the terms and conditions of the company's Equity Incentive Plan and the individual grant agreement."
This protects the company if the board modifies the grant terms or if there are changes to the equity plan before the grant is formally approved.
What to Reference Separately
The offer letter should reference — but not attempt to reproduce — the following documents:
- Equity Incentive Plan — The governing document that establishes the rules for all equity grants
- Individual Grant Agreement — The specific agreement between the company and the employee for this grant
- 409A Valuation — The independent valuation that determines the exercise price for stock options
These documents contain detailed terms and conditions that are too extensive for the offer letter, including provisions for treatment of equity during corporate transactions, forfeiture rules, transfer restrictions, and tax withholding obligations.
Common Mistakes When Including Equity in Offer Letters
Guaranteeing Specific Values
Never suggest or imply that the equity will be worth a specific dollar amount. Equity value depends on company performance and market conditions, and projecting future values creates liability.
Avoid: "These 25,000 options could be worth $500,000 based on our current growth trajectory."
Better: "The value of these options will depend on the company's performance and the market price of the shares at the time of exercise."
Omitting the Board Approval Condition
Some companies forget to condition the equity grant on board approval. Without this condition, the offer letter itself could be interpreted as a binding grant commitment before the board has taken formal action.
Using Inconsistent Terms
Make sure the equity terms in the offer letter match what the board will approve. If the offer letter says "ISOs" but the board grants NSOs, or if the vesting schedule differs, you have a discrepancy that can create disputes.
Ignoring Tax Implications
While the offer letter does not need to provide tax advice, it should note that equity compensation has tax consequences and recommend that the candidate seek independent tax guidance. For ISOs, you might mention the concept of an 83(b) election where applicable for restricted stock.
Failing to Mention the Cliff
The one-year cliff is a significant term that candidates need to understand. If an employee leaves before the cliff, they receive zero equity. This should be clearly stated.
Presenting Equity Effectively
Context for Non-Technical Candidates
Not every candidate understands equity terminology. Consider including a brief explanation or offering to schedule a call to walk through the equity terms. This is especially important for candidates who are new to startup compensation.
Total Compensation Summary
Include equity in a total compensation summary alongside base salary and other cash compensation. While you cannot guarantee the future value of equity, you can present the grant in the context of the overall package.
Generate Your Offer Letter with PactDraft
PactDraft's offer letter generator includes a comprehensive equity section that covers stock options, RSUs, vesting schedules, and essential disclaimers. Answer a few questions about the equity grant, and PactDraft produces properly structured language that protects your company while clearly communicating the offer.