At a certain point, founders of an emerging startup face a predicament: the need to assemble a talented team without the cash to pay for it. This is where equity compensation, such as stock options and restricted stock, can serve as a powerful tool. Equity compensation helps the company attract and retain skilled workers, incentive longevity and performance, and align the interest of the company with its employees and service providers.
Founders often have questions about the various types of equity compensation and how they work. This article provides a brief overview of the most common types of equity compensation used by early-stage startups – stock options and restricted stock – provides pros and cons of each, and describes additional features and consequences of equity compensation, such as vesting, acceleration, and tax considerations.
Types of Equity Compensation
There are many types of equity-based awards available to companies. The most commonly-used by startups are stock options and restricted stock. Additional forms of equity compensation include restricted stock units (RSUs), stock appreciation rights (SARs), phantom stock, and performance awards, but this article focuses on the awards typical to early-stage startups.
All awards should be granted under an equity incentive plan adopted by the company’s board of directors and shareholders. If appropriately drafted and adopted, the plan will provide an exemption from securities law registration requirements; a critical feature for any private company.
Founders should be mindful that each award dilutes the ownership of the founders and other stockholders. Founders should be deliberate in making awards to ensure that they do not surrender too much of the company’s ownership. For an early-stage startup, an initial allocation of around 10% to equity compensation is typical.
Stock Options
Stock Options are the equity award of choice for startups. A stock option provides the recipient with the right to purchase stock at a predetermined price, called the “exercise price” or “strike price”, in the future. The exercise price is typically set at the fair market value of the underlying stock on the grant date, so the recipient benefits from future appreciation in the value the stock. Essentially, the recipient can buy stock tomorrow at today’s price.
Unless and until a stock option is exercised, the recipient does not own any stock – he or she merely owns the option to buy stock – and therefore has no voting, dividend, or other shareholder rights.
Stock options come in two flavors. Incentive Stock Options (ISOs), which may be granted only to employees, potentially provide the recipient with favorable tax treatment if certain criteria are met, including that the recipient holds the shares underlying the ISO award for both (a) one year from the date the recipient exercises the ISO, and (b) two years from the grant date. All other stock options are Non-Qualified Stock Options (NSOs). NSOs may be granted to employees, directors, and other service providers. NSOs are more flexible than ISOs but do not offer the favorable tax treatment for which ISOs are eligible.
Stock options are not taxable upon grant. ISOs are not taxable upon exercise; NSOs are taxable upon exercise at ordinary income rates on the spread – i.e., the excess of the fair market value of the shares acquired on exercise over the aggregate exercise price. When the underlying shares are sold, eligible ISOs are generally taxed at long-term capital gains rates on the difference between the exercise price and the sale price; NSOs are generally taxed at capital gains rates on the difference between the fair market value at exercise and the sale price.
Pros of Stock Options
- Incentivize recipients to increase the company’s value; an increase in the company’s value results in an increase in the option’s value.
- Allow the recipient to determine when to exercise the option and therefore dictate when tax will be imposed.
- From the company’s perspective, avoid the burden of having to confer voting and other stockholder rights on potentially a large number of small holders, since the recipients do not hold stock unless and until the options are exercised.
Cons of Stock Options
- Do not have retentive value if the company’s stock price is not increasing; no increase in the company’s value results in no increase in the option’s value.
- Require the recipient to come up with cash to pay the exercise price and receive the benefit.
- Require a valuation of the company’s stock to set the exercise price at fair market value.
Restricted Stock
Restricted stock is stock that is subject to certain restrictions until it vests. Unlike stock options, a restricted stock award is a grant of actual stock, so the recipient becomes a shareholder, generally entitled to voting, dividend, and other shareholder rights upon grant. For startups, restricted stock is sometimes used to attract experienced senior executives who may prefer it to stock options.
The primary restriction on restricted stock is vesting. While the recipient receives the full amount of the stock upfront, unvested shares are forfeited to the company, or repurchased by the company at the price paid for the stock (if any), upon the termination of the recipient’s employment or service relationship. Some companies also retain the right to repurchase vested shares at fair market value upon termination. Restricted stock is subject to additional restrictions, such as limitations on transfer.
By default, restricted stock is taxed as it vests. On each vesting date, the recipient is taxed at ordinary income rates on the difference between the amount paid for the stock (if any) and the fair market value of the stock on that date.
However, recipients may make an 83(b) election with the IRS within 30 days of the grant, electing to be taxed on the difference between the amount paid for the stock (if any) and the fair market value of the entire grant on the grant date (rather than on each vesting date). An 83(b) election is advisable if the fair market value of the stock is low at the time of grant (and is the clear choice if the fair market value is close to $0, such as in an early-stage startup, or if the recipient paid fair market value for the stock) and can have a very significant tax benefit if the shares become more valuable in the future as vesting occurs.
When the restricted stock is sold, the recipient will generally be taxed at capital gains rates on the difference between the sale price and the fair market value of the stock at the time of vesting (if no 83(b) election is filed) or at the time of grant (if an 83(b) election is filed).
Pros of Restricted Stock
- In general, will always have some economic value to the recipient since no future payments, such as an exercise price, are required.
- May be used to attract senior-level executives or other key employees.
- Do not require recipients to pay an exercise price to realize the value of the award.
- Do not require valuation of the company’s stock for issuance.
Cons of Restricted Stock
- Recipients will have tax liability on each vesting event (if no 83(b) election is filed) or upon grant (if an 83(b) election is filed) when the shares are illiquid and the future prospects of the company (and the stock) are uncertain.
- From the company’s perspective, confer voting, dividend, and other shareholder rights on the recipient.
- Results in additional shareholders for the company to account for.
Vesting
Nearly all equity compensation is subject to vesting. Vesting requires the recipient to remain with the company in order to “earn” the equity compensation, rather than receiving the full benefits upfront before putting in any sweat.
For most employees, vesting is typically time-based over “four years with a one-year cliff”, meaning that 25% of the award vests after one year of service (the “cliff”) and the remainder vests monthly over the following three years of service, such that the entire award is vested after four years. Vesting can also be based on the achievement of performance goals, or a combination of time-based and performance-based vesting.
In the context of a stock option, a recipient may exercise only the options that are vested at the time of exercise. In the context of restricted stock, the recipient receives the full amount of the award upfront, but if his or her employment or service relationship is terminated the unvested restricted stock is forfeited to the company or repurchased by the company at the price paid for the stock (if any).
Awards may provide for acceleration – meaning that all unvested awards become immediately vested – based on a sale of the company. Acceleration may be “single-trigger”, meaning it occurs automatically upon the sale of the company, or “double-trigger”, meaning that it occurs only if there is both a sale of the company and a second event (typically a termination of employment by the company without cause or by the employee with good reason) within a specified period after the sale.
Conclusion
Equity compensation is a critical tool for early-stage startups to attract top-level talent, align the interests of the company and its employees and service providers, and allow employees and service providers to share in the growth and successes of the company. Founders should be deliberate when considering equity awards and fully understand the consequences of the awards on the company, its shareholders, and the recipients.