Scaling depends on your ability to obtain, retain, and motivate your team.
For companies with limited access to capital one of the most effective ways to obtain, retain, and motivate a talented team is through equity compensation.
The core characteristics of equity(e.g., appreciation tied to company growth) tends to promote an alignment between the company and its stakeholders. Equity alone, however, is not replacement for building a strong culture.
“Anyone who prefers owning a part of your company to being paid in cash reveals a preference for the long-term and a commitment to increasing your company’s value in the future.”
– Peter Thiel
There are several types of equity compensation and a variety of considerations to determine which type is appropriate in a given situation. Today, we’ll focus on restricted stock and stock options.
We also discuss employee equity in more detail in this video.
Restricted Stock
Restricted stock is commonly used to compensate the founders and early team members.
Right of Repurchase
Generally, restricted stock is“restricted” because it is subject to the company’s right to repurchase the stock at the lesser of: (a) the price of the stock at the time it was granted, or (b) fair market value at the time of repurchase.
Vesting
The company’s ability to repurchase the stock, however, is generally lifted once the stock vests.
Vesting is often tied to conditions that must be satisfied–such as time (e.g., staying with the company for 4-years),performance goals (e.g., sell 10,000 products), or a combination of time and performance.
Ordinarily, vesting is time-based. Usually, 4-years with a1-year cliff.
The cliff designates the amount of time that the recipient must stay with the company before any of the stock vests. Once the cliff is satisfied a percentage of the stock will vest (usually 25%).
We often use the fictional (as far as we know) laundry marketplace called“WeWash” as an example:
On January 1, WeWash offers Carol 100,000 shares of restricted stock subject to a 4-year vesting schedule with a1-year cliff. On January 1stof the following year, 25,000 shares will vest and be released from WeWash’s right of repurchase.
Vesting may accelerate upon certain events, such as a sale of the company and may be forfeited upon certain events(e.g., disclosing trade secrets).
Even though restricted stock is subject to vesting, the recipient is still the beneficial owner of the stock and the rights related to stock ownership (e.g., voting rights).
We cover vesting in more detail in this video.
83(b) Election
One potential advantage of restricted stock is the ability to file an 83(b) election.
Without an 83(b) election, the value of the restricted stock is taxed as the stock vests. Although tax deferral may sound like a benefit, that is not often the case for venture-backed companies.
This is because restricted stock is commonly granted at a time when the company has very little value, but anticipates rapid growth.
For instance, Carol may be the first hire or even a founder, and the company may be able to issue the restricted stock at par value (e.g., $0.00001) because that is the fair market value of the stock.
By filing an 83(b) election within30 days of receiving the stock, Carol tells the IRS that she wants to be taxed on the full value of the stock now (e.g., $1.00 (100,000 shares times $0.00001)).
If Carol did not filed an 83(b)election, the stock is taxed in the year in which it vests and Carol must include the increase in value as ordinary income on her tax return.
Because WeWash is a high-scale technology company, the value of its stock may increase rapidly over the course of the 4-year vesting schedule. So,Carol will be taxed on the increasing value each time the stock vests.
For the purposes of the example, let’s assume that on the 1-year anniversary of the grant date (which vested 25%of the stock or 25,000 shares), the value of WeWash’s stock increased from$0.00001 to $1.00 per share.
If Carol didn’t file an 83(b)election, on the 1-year anniversary, she would be taxed on the appreciation in value ($24,999.75, being ($1.00 (fair market value at the time of vesting) minus $0.00001 (value at the time of grant),resulting in a per share increase of $0.99999 multiplied by 25,000shares (the vested amount on the 1-year cliff)).
Because WeWash is a private company,Carol can’t sell a portion of her shares to cover the tax liability related to the increase (known as “phantom income”). That is one reason an 83(b) election is advantageous for her (e.g., she can choose to be taxed on full at the time of grant).
Options
Instead of restricted stock, companies may incentivize employees with stock options. Options are not stock, but the contractual right to buy a set number of shares in the future at a fixed price.
This fixed price must be at least the fair market value of the stock when the option is granted (known as the“strike price”).
Unlike the recipient of restricted stock, the recipient of an option does not have any rights as a stockholder(e.g., voting rights) until the option is exercised.
Like restricted stock, options are often subject to vesting. Let’s go back to Carol, but this time with options:
On January 1, WeWash offers Carol options to purchase 100,000 shares of common stock, at $0.01 per share, which is subject to a 4-year vesting schedule with a 1-year cliff.
In this example, 25% of the options vest on the 1-year anniversary of the grant date (i.e., Carol can exercise the option by paying the per share strike price ($0.01)).
As with restricted stock, employees are incentivized by options because the value of the underlying stock could increase substantially over time.
If the fair market value of the stock jumps from $0.01 to $0.25 per share, Carol can exercise her options(assuming they have vested) to capitalize on the increase in value—the difference between the strike price and the fair market value at the time of exercise is known as the “spread”.
Because the stock available for purchase under the option may appreciate substantially, Carol is incentivized to align her interest with the company.
Also, because WeWash is a private company, Carol will (generally) only be able to sell her shares upon a liquidity event (e.g., sale of the company) or once the WeWash goes public.
This further incentivizes Carol to create long-term value.
We cover stock options further in this video.
Tax
Unlike restricted stock, options are not taxed on grant or vesting. How an option is taxed upon exercise depends on the type of option.
Incentive Stock Options (“ISOs”)
If certain holding periods (and other requirements) are satisfied, ISOs may receive favorable tax treatment.
If an ISO (and underlying stock) is held for more than 1-year after it is exercised and 2-years after the date the option was granted, then the recipient will not owe federal income tax upon exercise.
By satisfying the holding requirements, the recipient may receive long-term capital gain treatment on a later sale of the underlying stock.
However, the spread may be subject to the Alternative Minimum Tax.
Importantly, the company is not required to withhold employment taxes upon the exercise of an ISO.
Unlike NSOs, (below), ISOs are only available to employees.
Non-Statutory Stock Options or Non-Qualified Stock Options (“NSOs”)
NSOs are options that do not qualify or are not designated as ISOs. NSO’s that are vested upon exercise are taxed as ordinary income on the spread, which is subject to withholding.
For an NSO, the holding period for capital gain treatment begins upon exercise, and because the spread is treated as ordinary income, the company receives a corresponding deduction.
Unlike ISOs, NSOs are not limited to employees.
Stock Plans
Equity incentives are usually offered to employees and service providers through stock plans, which must be adopted and approved by the Board and stockholders.
The stock plan reserves a certain portion of the company’s authorized shares for distribution under the plan(often called the “employee equity pool” or “option pool”).
Investors usually require a company to reserve a certain percentage of their shares under the equity pool prior to making an investment.
We discuss this in more detail here.
Conclusion
Employee equity incentives are a useful tool for early-stage companies. They promote stakeholder alignment and building long-term value.
Because equity incentives are “securities”and are issued as compensation they are subject to complex state and federal securities and tax laws. The failure to navigate these laws properly can have drastic and unintended consequences.
Photos by Gerald Berliner on Unsplash
Fine Print
This post should not be construed as legal advice for any particular facts or circumstances and is not meant to replace competent counsel. None of the opinions or positions provided are intended to be treated as legal advice or create an attorney-client relationship. This content may not reflect all current updates to applicable laws or interpretive guidance, and we disclaim any obligation to update this video.
