Decoding employee equity
In the UAE’s vibrant startup ecosystem, incentive-based compensation is redefining how companies attract and retain top talent. Karm Legal Consultants offer expert legal insights on factors to consider while designing employee benefits.
Beyond a fixed salary, startups in fast-paced industries like technology and finance often turn to incentive-based compensation models to attract and retain top talent. These compensation models transcend conventional cash-based structures and are widely regarded as an effective means of rewarding and retaining key talent by aligning their interests with the long-term success of the company.
In the early stages of a startup’s growth, one of the easiest, yet equally tricky forms of rewards available to founders involves equity or equity-like (not involving issuance of actual equity shares) incentives. As a result, granting direct ownership in the form of equity or providing financial rewards (that may or may not be linked to the value of the startup’s equity) is very common. These models are frequently used to attract and retain key talent and are often extended to employees, consultants, and advisors.
Some non-equity incentives are structured to simulate ownership or reward value creation without altering the shareholding or capital structure of the startup. A key consideration, when designing benefits would be whether to offer equity-based or non-equity-based incentives.
FACTORS TO CONSIDER
When deciding between equity-based and non-equity-based employee benefits, startups should evaluate:
(a) Capital dilution: Issuing equity to employees, consultants, and advisors impacts ownership and control over the company. This has a direct impact on the fully diluted capitalisation table of the company and can reduce founders’ or early investors’ stake.
(b) Stages of a startup’s lifecycle: Early-stage startups may lack the relevant resources to allocate equity meaningfully and may prefer virtual stock option schemes (VSOPs) or bonuses to retain exceptional and founding talent. Equity plans may be often more relevant, when a startup is more mature and there are a sizeable number of employees and advisors who are key to the business’ growth and need to be secured by way of equity.
(c) Future fundraising plans: Fundraising events often require clear documentation of outstanding equity commitments. Investors may typically demand a pre-defined employee stock option pool (ESOP) (often ~10–15 per cent) to be carved out pre-money, thereby reducing dilution to their stake. This requires proactive planning on a startup’s part and legal clarity on equity issuances and promises.
(d) Employee performance metrics: In both equity and non-equity-based employee benefits, startups should consider clearly outlining the performance measures of the individual receiving the benefits. This would include identifying trigger events, targets, termination for and without cause, etc. This is to ensure that the eligibility to receive benefits is clarified within the relevant documentation.
FORMS OF EMPLOYEE BENEFITS
Below, we look at the forms that employee benefits can typically take:
1. Equity-based benefits
Equity-based benefits involve giving participants a right to own part of the company, typically through:
(i) Vesting of shares – for key persons: Founders’ and key persons’ shares are typically governed by vesting schedules designed to align long-term commitment with the strategic objectives of the company. These schedules commonly span a period of 2-4 years and generally commence with a 1-year “cliff” — a minimum service period after which the initial tranche of shares vests. Thereafter, the remaining equity typically vests in equal monthly or quarterly instalments over the balance of the vesting term.
In the case of individuals who are subsequently recognised as co-founders, or non-founder key persons brought in at later stages, the vesting of equity is often contingent upon the achievement of pre-agreed performance milestones or deliverables, including business development targets, product launch timelines, fundraising objectives, or other strategic contributions, intended to ensure that equity is allocated in a manner that reflects actual value creation and aligns with the evolving needs of the business.
(ii) Employee Stock Option Plans (ESOPs): ESOPs specifically targeted at employees, provides employees with the contractual right, but not the obligation, to purchase a specified number of company shares at a predetermined exercise price, typically after satisfying certain vesting conditions. ESOPs are commonly used as a strategic tool to attract, retain, and incentivise key talent by offering an opportunity to participate in the long-term growth and value of the company.
Vesting under an ESOP is generally structured to promote sustained employee engagement and performance. Typical vesting schedules may include a time-based “cliff,” often one year. Following the cliff, the remaining options usually vest in equal monthly or quarterly tranches over a specified duration. In some cases, vesting may also be linked to the achievement of individual or company-wide performance milestones, aligning employee interests with broader business objectives.
2. Non-equity-based benefits or long-term incentive plans
Non-equity incentives allow companies to offer performance-linked financial rewards, typically without the restrictions and procedural hurdles which may be linked to an issuance of shares.
(i) Phantom Shares/VSOPs: VSOPs/phantom shares are typically a contractual promise to receive a cash amount equivalent to the value of a defined number of shares of a company, calculated at a liquidity event. Since phantom shares do not actually result in an issuance of equity, they avoid the regulatory complexity involved in the issuance of shares, and do not result in the alteration of a capitalisation table.
(ii) Milestone or profit-sharing bonuses: Bonuses offer a simpler alternative, especially in early stages or onshore companies with legal limitations on share issuance. Bonuses, which may be tied to revenue or product launches, can be structured to align employee incentives with business performance.
JURISDICTIONAL CHALLENGES IN THE UAE
The legal framework governing a corporate entity is a critical consideration in selecting the most suitable employee benefit program. The UAE, as a legal system, may pose some challenges for startups looking to offer these benefits to key persons. Under the Federal Decree-Law No. 32 of 2021 on Commercial Companies, the ability to issue negotiable shares is not available to all forms of corporate bodies. For instance, only joint stock companies can issue negotiable shares. Even in such cases, the law generally mandates that shares be of the same class and type. These constraints pose notable challenges in the design of equity-based incentive schemes, particularly for companies established in mainland UAE, where the creation of shares with limited voting or economic rights may be restricted.
In contrast, the financial freezones offer a different kind of flexibility in this respect:
Free Zones – ADGM, DIFC, DWTC, RAKICC, RAK DAO, DSO
- ADGM: Governed by the ADGM Companies Regulations 2020, ADGM entities may issue multiple share classes, define tailored shareholder rights, and structure ESOPs via detailed equity incentive plans. ADGM is modeled on English common law, making it a preferred jurisdiction for VC-funded tech startups.
- DIFC: Under the DIFC Companies Law No. 5 of 2018, similar flexibility is granted. ESOPs, convertible instruments, and equity-linked compensation are legally recognised and widely used. DIFC also permits employee benefit trusts to administer such plans.
With the growing startup ecosystem, the UAE’s financial free zones, now offer much needed flexibility to the founders to adopt such internationally accepted incentive schemes and plans.
CONCLUSION
The UAE’s diverse legal framework, spanning across the mainland and the free zones, requires startups to carefully assess their commercial objectives before designing incentive plans. Legal structuring is essential to ensure enforceability, tax compliance, and corporate governance. Given the evolving regulatory environment in jurisdictions like ADGM and DIFC, startups should seek specialist legal counsel when implementing such schemes. By aligning compensation with long-term value creation, well-structured incentive plans can serve as a powerful tool for attracting, retaining, and motivating the teams that drive startup success in the UAE.
Text by:
- Soumya George, of counsel, Karm Legal Consultants
- Tanvi Ahuja, associate, Karm Legal Consultants
