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What Type of Equity To Give Startup Employees

 

You’re a Seattle startup. What you have is a great idea; what you lack is cash flow. But to build out your great idea, you need employees. And at some point, you’ll need executives, advisers, directors, and others.

So, like most other startups, you’ll need to offer some kind of alternative compensation to woo these people away from their high salaries and good benefits at the established corporate jobs they keep.

Here are a few common types of compensation to consider:

  1. Restricted Stock

  2. Stock Options

  3. Restricted Stock Units

  4. Stock Appreciation Rights & Phantom Stock

Disclaimer: this post covers common forms of equity for C-corporations, but not LLCs.

Restricted Stock

Restricted stock (sometimes referred to as “founders stock”) is typically given to founders and other initial employees of the startup when the company is in its infancy.

At that point, restricted stock can usually be purchased for a very low price, as the share value is quite low when the company is just getting started (e.g., one-tenth of one percent). This gives the startup’s big risk-takers the prospect of a big reward down the line.

When restricted stock is granted, the shares are fully issued, which gives instant value to the owner. In addition, the owner has shareholder rights, including the right to vote and receive dividends. But the shares can’t be sold and they may be forfeited until they vest. Shares usually vest on the basis of time (e.g., four years with a one-year cliff) or performance (e.g., the company or employee hits a milestone) or both, in some combination.

Restricted stock grants are usually common stock—not preferred stock, which is typically reserved for outside investors. The basic difference between common and preferred stock is that the latter has rights, preferences, and privileges that the former lacks. Chief among these is a liquidation preference, which ensures the preferred stock owners get paid before the common stock owners (including the founders) if the startup is sold or otherwise liquidated.

To founders, it might seem unfair to give away this kind of preference (among others) to investors. But the reality is that institutional investors, like venture capital firms, will insist on getting preferred stock in exchange for their investment, and so there’s not much to be done for startups looking to get VC funding.

Stock Options

While startups often grant restricted stock to very early employees, stock options are the most common type of compensation granted to subsequent startup employees.

Stock options allow an employee to buy shares of stock at a fixed price—the “strike price”—in the future. The value to the owner is the difference between the strike price and the value of the shares at the time they’re purchased (assuming the latter number is higher).

Awards of stock options (as well as most other equity awards) are usually subject to a vesting schedule. A typical vesting schedule is 4 years with a 1 year cliff, meaning that no vesting occurs within the first year (the cliff) after which vesting occurs incrementally over the next four years.

Options may only be exercised for a fixed period of time, which is usually 7-10 years, so long as the employee is still with the company. This is known as the exercise window. However, if the employee leaves the company, then the options usually expire 90 days after termination.

There are two types of stock options: incentive and non-statutory.

Incentive Stock Options (ISOs)

Incentive stock options (also known as statutory stock options) can only be granted to employees. Because of this, and because ISOs may have beneficial tax treatment for employees, companies often grant ISOs to select members of management or other important employees.

The tax benefits of ISOs for employees is a subject that’s beyond the scope of this post. However, in brief, ISOs are taxed on a capital gains basis, rather than as ordinary income, so long as certain requirements are met.

Nonstatutory Stock Options (NSOs)

Unlike ISOs, nonstatutory stock options (also known as non-qualifying stock options) may be granted to anyone who provides services to the company, including employees, officers, directors, and independent contractors.

In general, the tax treatment of NSOs is less favorable than ISOs, as NSOs are taxed at ordinary income rates, rather than at the capital gains rate.

Restricted Stock Units

Startups don’t typically grant restricted stock units. RSUs are much more common for larger companies (think Google, Facebook, Amazon), for reasons explained in more detail below.

But before getting into that, what exactly are RSUs? RSUs are in essence an agreement by the company to give an employee shares of stock or the cash value of such shares at a later date. Each unit is equivalent to a singe share of stock or the cash value of that stock when it’s received—a time known as the “settlement date.” Like other forms of equity, RSUs usually vest based on a certain period of time or a major event (like an IPO).

The reason RSUs aren’t commonly used by startups comes down to how they’re taxed. If a startup awards an employee RSUs that will vest at a later date, these units will be taxed according to their vesting schedule. If the RSUs are worth a great deal once they vest, the employee will then owe a big chunk of tax on the units, which could create serious financial problems for the employee.

But…wouldn’t the same thing happen to employees at larger, more established companies?

Well, yes, but those companies are often better equipped than a startup to help employees handle the tax problem. An established company will usually have the capital to help employees with these tax payments. In fact, if it’s a public company, then it’s probably put in place a program for selling shares to help pay these kinds of taxes.

Startups, on the other hand, rarely have cash just lying around. This leaves them unable to help employees facing a big tax bill. For this reason, it’s usually better for startups to stay away from RSUs.

Stock Appreciation Rights & Phantom Stock

Stock appreciation rights (SARs) and phantom stock may be used by startups, but they’re not nearly as prevalent as restricted stock and stock options.

SARs and phantom stock are essentially bonus programs that are linked to the company’s increasing value. Recipients are not granted actual shares of stock. Instead, they’re given the right to receive the cash equivalent of shares at a future time (phantom stock) or the increase in value of the shares (SARs) over time.

Bonus programs like this can be nice for companies that want to reward employees without actually having to give up any equity. And some employees actually prefer these types of awards because they don’t have to invest their own money as they would for equity awards like stock options. In other words, recipients of SARs and/or phantom stock get the financial benefit of having stock without the risk of actually buying shares. Of course, they lose out on some of the advantages of owning shares, like voting power, but for those employee concerned primarily with the financial benefits, control is of little concern.

Takeaways

So, what type of compensation should you use? As a startup, you’ll probably end up using a combination of restricted stock and stock options to compensate your team. Hopefully you have a better handle of why after reading this post.

However, before you make any decisions, please consult with a good lawyer. This stuff is complicated and it’s really important to get professional help before you start parceling out pieces of your company.

While the goal of this post was to provide a high level overview of startup equity compensation, I’m sure some readers will be looking for a deeper dive into this highly complex subject. If so, I strongly recommend this guide, which was co-authored by Joe Wallin, a really smart Seattle startup attorney.

Still have questions? If so, ask away in the comments section below.