In earlier posts (here and here) we discussed important points to getting a startup off the (legal) ground the right way. This is continuation of that discussion, focusing on equity incentives.

Equity incentives are fairly intuitive: team members get equity in the company (or options to buy equity) on the assumption that its value will increase over time and that equity is frequently subject to future vesting to encourage team members to stay and contribute to the growth of the company. In the startup context where cash for salaries is precious, equity incentives may have an even bigger role.

For our purposes, startup equity incentives come in two basic types – restricted stock and stock options. There are more exotic equity and equity-like incentive schemes (for instance, stock appreciation rights, phantom stock, profits interests, etc.), which don’t fit well in startup context.

Restricted Stock – Restricted stock is, fundamentally, stock that is issued to a service provider (who becomes the record owner) that is subject to a substantial risk of forfeiture if the vesting conditions are not met. Vesting (meaning, when the service provider is objectively allowed to keep the shares) usually happens by continued service through various future dates (although other milestones can be used as well). For instance, an award will vest over 4 or 5 years with a 1st year “cliff”, where the employee doesn’t vest in any of the shares unless they stay for the first year and vest in 20 to 25% of the total grant, with the remainder vesting ratably each month for the rest of the period. Mechanically, the “risk of forfeiture” means a right by the company to buy the unvested shares back from the employee at the original grant price if employment ends before the shares vest.

Restricted stock will also be “restricted” in the sense that it cannot be transferred by the recipient before it vests, and even after it vests can be transferred only in limited circumstances.

  • Taxes – as with all compensation, taxes play an important role in equity incentives. Federal income tax by default includes in the recipient’s income restricted stock when it vests (meaning, their income for the year in which vesting occurs includes the difference between the value paid for the vested shares and the FMV of those shares when they vest). This means that if there is a significant increase in the value of the company during the vesting period, the employee could have a significant tax impact when vesting occurs, and since the vested shares will still be illiquid, no cash to pay the tax.
  • 83(b) Election – To address this, recipients of restricted stock can make an election under §83(b) to be taxed on the full amount of the restricted stock the year they get the award, even before it vests. When this election is made, the difference between the FMV of the shares and the amount the employee pays for them is included in ordinary income. For this reason, restricted stock makes the most sense for founders/employees at the very early point after the company is formed (before a significant equity funding event, for example), when its equity does not have a high FMV. If the restricted stock has a sizeable FMV when granted, either the employee will have to pay the company a measurable amount of cash to buy the shares or will have a measurable impact in ordinary income.
  • 83(b) elections have a short 30-day filing deadline, which can be easily overlooked where the service provider/employee doesn’t understand that they need to get the election filed within that deadline. While the filing obligation is on the recipient, it’s a good idea for the company to make sure the election form is completed at the time the grant documents are signed with the employee and they are reminded that they need to file it.

  • The company has an interest in whether an 83(b) election is made too: the company takes a deduction in the same amount and at the same time as the employee recognizes income. Further, restricted stock is compensation (as we said above) and unless an 83(b) election is made, the company has to withhold and report as the stock vests.

Options – Options are a right to buy a fixed number of shares at a fixed purchase price per share, and are generally also subject to the same-time based vesting requirements that apply to grants of restricted stock (there are also “early exercise” options that include a function similar to 83(b) discussed above). Options themselves (generally) come in two varieties: (1) “Incentive Stock Options” (ISOs) and (2) any option that fails to qualify as an ISO (NQSOs or non-statutory options).

In general, options do not result in an income event for the recipient when they are granted or when they vest, which is helpful to the recipient. On the other hand, options must be granted at the FMV of the underlying stock to avoid complications under §409A of the Internal Revenue Code (a topic that is outside the scope of this post). This FMV requirement can be difficult for a startup to address because its stock inherently lacks a trading market and it must rely on other valuation methods.

  • NQSOs – As noted, an NQSO isn’t taxed at grant date or at its vesting. It is however taxed at the exercise date (if it is exercised) on the difference between the exercise price and the FMV of the stock (and the company is required to withhold on that income). Once exercised, the long term capital gains holding period begins to run.
  • NQSOs can be granted to a wider group of service providers than ISOs; only employees can receive ISOs.

  • ISOs – In theory, if an ISO is exercised and the stock held for 1 year after the exercise date and two years from the grant date (not taking into account the vesting period, which may have delayed exercise for a period of time), all gain or loss is long term capital gain or loss. If any other disposition that doesn’t satisfy these tests occurs, the impact is ordinary income recognition on the difference between the FMV on the exercise date and the exercise price.
  • ISOs can only be granted to employees (so non-employee directors and independent contractors are ineligible)

  • The Alternative Minimum Tax applies to exercises of ISOs

  • ISOs have special rules for employees who own more than 10% of the voting power of the company

  • The ISO rules also have special limitations on individuals receiving options worth more than $100,000 in any calendar year

Notwithstanding the hypothetical benefits of ISOs versus NQSOs, most employees will not exercise options in the absence of an established trading market for the underlying stock (meaning, an IPO has happened or is somewhere on the horizon) unless they have comparatively low exercise prices relative to the perceived value of the company. Realistically, most employees will receive value for their options in a sale of the company, which will generally result in ordinary income to them.

The Plan Document – Most equity incentive plans are a single document that will, at a minimum, allow grants of restricted stock and both types of stock options. As discussed in an earlier post, having a written plan is important to several aspects of securities compliance as well. Ideally, the plan will also have easy to use grant agreements that spell out the specifics of individual grants (frequently in a “check the box” format) to make administration simpler. Administration of the plan in the early days is usually given to the Board of Directors, though later as the company grows it may be administered by a compensation committee of the Board. We plan to discuss record keeping in detail in a later post, but it’s worth stressing here that the company should promptly document board approval of grants and document the grants themselves (the instruments the recipient gets that form the contractual basis of the grant) and maintain an accurate inventory of such grants. The plan will need to be approved by the Board of Directors, and (as we assume that most plans permit ISOs) by the stockholders within 12 months of plan adoption.