Why should startups care about equity compensation?
Initially, it can be hard for startups to attract and retain talented employees as they lack the resources to be able to pay key employees attractive or even market salaries. Instead, startups can use various forms of equity compensation to make up for this by offering certain employees additional income in the form of equity and the ability to acquire ownership in the company. Equity compensation is a great way to align the company’s and employee’s interests as well as incentivize the employee.
Below is an overview of common types of equity compensation that startups can use. However, before using any type of equity compensation, it is important to understand the legal and tax implications of each of them.
Common types of equity compensation
Restricted stock is a grant of stock to founders or key employees with restrictions attached such as a restriction on transfer or the company’s right to repurchase the stock for a certain period of time if the employee’s employment ends. Restricted stock typically vests over a period of time (typically 4-5 years) or is based on performance goals. The vesting of stock in stages is critical for startups because it helps to incentivize employees to stay with the company until their stock vests and not end up with a windfall of the company’s equity and then leave.
Restricted stock is usually purchased for a nominal amount ($0.001). The holder of the stock should make a Section 83(b) election within 30 days of transfer of the stock so they are taxed on the value of the stock at the grant date. If this election is not made, the holder will be taxed on the difference between the purchase price and the fair market value of the shares when the shares vest which will be significantly more at this point. And, since this is restricted stock, there is likely no way for the stock holder to sell the stock to cover the tax burden.
An option is the right to purchase a specific number of shares at a specific price. Typically, options have similar vesting schedules as restricted stock for the same incentive reasons. The exercise price is usually the fair market value of the stock at the time the option is granted and are usually exercisable for 5-10 years after the options vest. Stock options can be either non-qualified stock options (NQSOs) or incentive stock options (ISOs).
NQSOs are options that are granted to people for their services to a company such as employees, independent contractors, or independent board directors. The option holder does not have to be an employee. The person who exercises a NQSO is taxed on the difference between the fair market value of the stock on the exercise date and the price paid for the stock.
ISOs are stock options that are only available to employees. ISOs are subject to capital gains rates, not ordinary income rates, provided that the required holding periods are met. Furthermore, to qualify as ISOs, additional requirements must be met such as only granting to employees and granting them under an approved plan. There are quite a few requirements and a company should be sure that all of them are met.
There are other types of equity compensation that startups can use not described here such as restricted stock units. Also, there are many other tax implications of each of these types of equity compensation that were not discussed. Click here for a more broad discussion of legal issues that startups face.
For a consultation about which type of equity compensation is right for your company, please contact Miles Williams at firstname.lastname@example.org and view our services to see how we can help grow your business.