Beyond the Pitch
Business Equity Compensation: A Tutorial for Busy Entrepreneurs
Equity compensation is a tool for cash-strapped startups to attract, retain, and motivate key employees with a future interest in the company. Equity compensation can also be an effective method to compensate key business partners, corporate advisors, and board members when the company is pre-revenue. As a company grows, equity can also be used as a bonus or as compensation for achieving key business targets or goals.
Build an Equity Compensation Plan With Legal Counsel
Even though a startup’s early equity agreements with key employees and business partners are likely to be negotiated individually, the first step in developing equity compensation alternatives is to create an equity compensation plan specific to the business. Engage legal experts with experience to create an equity plan that is appropriate for a startup company.
The plan document should include the available pool of equity, the eligible individuals (employees and others), the company’s menu of compensation alternatives, default vesting provisions and restrictions on vested equity awards, the basis for equity awards, as well as who will award equity and when.
The equity comp plan document should be accompanied by other documentation required for an equity award, including a form equity award agreement, notice of option exercise, board resolutions approving the plan, and forms related to Section 83(b) elections. (See below.).
With a flexible yet encompassing plan in place, a company has standard terms for options awards that have passed legal review. The plan will serve as the starting point when the company chooses to tailor unique equity award agreements with individual employees. Any deviation from the form equity award agreement should be reviewed by the company’s legal counsel as well as by the company’s board of directors.
Common Types of Equity Compensation for Startups
When determining the most beneficial equity compensation form to award, a new company should consider vesting alternatives, the price (if any) the recipient will pay for the equity, trigger events for payment, restrictions on future transferability, forfeiture provisions, and intended tax consequences. The following is an overview of types of equity compensation commonly awarded.
- Incentive Stock Options (ISO) are a type of company stock option (also sometimes referred to as Qualified Stock Options) that can be granted only to employees. ISOs have potentially favorable federal tax treatment for the recipient as the employee pays no tax when the options are granted and exercised. If the employee holds the shares for two years after the grant and one year after exercise, federal tax is at capital gains rates and only on the difference between the exercise and sale price.
- Non-qualified Stock Options (NQO), in general, are any option to purchase stock that doesn’t qualify as an ISO. They may be granted to employees or non-employees who perform services for the company. The recipient pays ordinary income tax rates on the difference between the exercise price and fair market value of the stock upon exercise. Appreciation at the sale of stock is taxed at capital gains rates.
- Restricted Stock is stock that is issued subject to certain vesting conditions set by the company, such as continued service to the company for a set period of time or attainment of certain performance goals. A multi-year vesting schedule is typical. When the stock vests, the fair market value of the stock (less any amount paid for the stock) is taxed as ordinary income. Appreciation at the sale of stock is taxed at capital gains rates. With restricted stock, Section 83(b) of the Internal Revenue Code allows employees to be taxed at the time of the grant rather than at the time of the vesting. The advantage is that ordinary income tax is paid on the immediate value and future value is taxed at capital gain rates. The disadvantage is that tax is paid up front on a stock that may decline in value or may never vest.
- Phantom Stock allows a business to confer many of the benefits of stock ownership to key employees without giving up actual company stock, and thereby diluting equity. Phantom stock follows the economics of the real stock (gains, losses, dividends, etc.) and gives the grantee the right to a cash payment at a certain time or upon the occurrence of a trigger event. There is no federal tax when phantom stock is granted, but phantom stock becomes taxable as ordinary income at vesting.
- Stock Appreciation Rights (SAR) is a performance bonus given to employees equal to the appreciation of the company’s stock over a specified period of time. Employees don’t have to purchase stock to receive the bonus, and it may be paid in stock or cash.
Equity compensation is complicated. First, understand what you are trying to accomplish with options or stock. Then, seek the advice of an attorney experienced in equity compensation plans for startups and a CPA who thoroughly understands potential tax consequences under various scenarios to the company and the grantee.
Miranda Morgan, partner Ice Miller LLP in Columbus, concentrates her practice in tax law, with a focus in gift, estate, individual income, and trust taxation. She advises individuals on estate planning, charitable planning, and wealth transfer planning. Miranda advises business owners on succession planning and equity compensation plans. Miranda received her Bachelor of Arts from The Ohio State University, summa cum laude. She received her juris doctorate from The Ohio State University College of Law, graduating with honors, and was the chief managing editor of The Ohio State Journal of Criminal Law. While practicing law, Miranda earned her Master of Laws in Taxation (LL.M.) from Capital University Law School, summa cum laude.
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