Equity vs. Options in Employee Stock Compensation

By Fernando Berrocal

The majority of early-stage businesses can’t afford to pay market-rate compensation to their employees. Cash flow is limited unless your business is well-funded. Fortunately, you have almost unrestricted access to another tool: “Business Equity”. Employees can acquire shares in your organization, and you can incentivize new hires by allowing them to partake in the upside of your organization's success through equity and equity options (and rising stock price).

Startup Stock Compensation Benefits

Restricted Stock, Stock Options, RSUs, and Tax Obligations:

Different types of equity options allow you to utilize vesting to make your early hires more likely to stay, in addition to helping you close the salary gap. Employees are incentivized to stay at least a year until their options mature, given a normal four-year vesting schedule with a one-year cliff. As a result, they don't leave on time, causing the organization to lose vital institutional knowledge.

Your employees are likely to be aware of the normal remuneration package for a startup and expect an equity offer from your business as well as an Employee Stock Option Plan (ESOP) offer letter as part of their startup employment agreement. Even while remuneration is only one component of how businesses reward their workers, know that, unlike contractors, you must treat employees fairly and provide all benefits required by local labor and wage regulations.

What is an equity award? There are just a handful of forms of equity awards employed in standard startup equity. Awards of equity are designed to recompense founders and other workers, not to pay or reward investors or service providers. There are 3 forms of equity awards that are commonly used at early-stage startups that contribute to your overall equity picture, alongside shareholder equity and your holdings (founders' common stock).

Restricted stock is often issued early in the organization's life cycle, before a 409a valuation, stock options are granted afterward, and RSUs are used in later-stage businesses before (or after) an Initial Public Offering (IPO). Since they appear to be similar, it's critical to understand where each grant fits into your overall equity strategy and how it will affect your total pre-funding startup equity. These are the distinctions between the 3 components of stockholder equity:

Restricted Stock: Also known as "restricted shares" because they are made up of many shares that have been awarded to employees, usually executives, and come with full voting rights. They frequently come with a vesting schedule that specifies when they may be sold, even if ownership is transferred at the moment of grant or purchase.

Restricted stock is taxed based on the difference between the Fair Market Value (FMV) and the price at which the stock is granted to the employee on the date they are exercised. Unless the business expressly allows the selling on secondary markets, the restricted stock usually can’t be sold until a trigger event happens, such as an acquisition or an initial public offering of the shares. Restricted stock gains are taxed at either the Alternative Minimum Tax (AMT) rate or the income tax rate in effect at the end of the calendar year in which they are exercised, whichever is greater.

If you exercise restricted stock early, you can make the 83b election, which means you won't have to pay any further taxes until the stock is sold, which will be eligible for lower capital gains taxes if it's 2 years or more after the issuance date.

Stock Options: These are options to acquire stock at a certain price on a predetermined date outlined in the stock grant. The stock is not issued until it is purchased, either before or after the vesting period established by their vesting schedule. Stock options have a time limit after which they can no longer be exercised. The strike price is determined at the time the options are issued. If a business approves the early exercise of unvested stock options, it can make an 83(b) election. Stock option taxation is a little more complicated since there are two types of options grants: Incentive Stock Options (ISOs) and Non-Qualifying Stock Options (NSOs).

Is it better to use ISOs or NSOs? Businesses will utilize ISOs to reward employees in the vast majority of situations since they have a lower immediate tax obligation and are thus more appealing vehicles. While NSOs can be given to contractors, consultants, and pretty much anybody, ISOs can only be given to employees.

How Are ISOs Taxed? ISOs are often more tax-advantaged than NSOs since employees holding ISOs don't have to pay taxes immediately after exercising their options. Those that use ISOs only have to pay taxes when they sell their stock. If an employee holds on to the shares for at least one year after vesting and at least two years after the award date, the profits are treated as capital gains rather than ordinary income. The good news is that you won't have to pay any ordinary or capital gains taxes on ISOs until you submit your taxes for the calendar year in which they were sold.

How Are NSOs Taxed? NSOs are distinct. Whether you keep or sell your stock options, the spread (difference between the exercise and grant prices) is included in your earned income and taxed at your regular income rate. Taxes on NSOs are deducted at the time of exercise. Payroll taxes (Social Security and Medicare) are also imposed on this earned income.

Stock Employee Compensation

Restricted Stock Units (RSUs): These are not stock, nor are they options and are similar to warrants, but do not expire and will always hold some notional value since they are typically only issued at businesses who have gone public or are about to.

They are an agreement between a business and an employee to issue a specific quantity of stock to an employee at a specific period. The stock has no worth until they have vested. The taxation of RSUs is straightforward and occurs when they vest. They are disclosed and taxed like ordinary income, and they may either be sold or kept. You'll send them documentation along with your offer letter once you've selected what sort of equity award to give them, and they'll need to fill out papers like equity purchase and restricted stock purchase agreements.

How to Plan for Employee Stock Tax Implications: Whether you obtain incentive stock options or non-qualified stock options, keep in mind that both are taxed and must be reported on your tax return. No matter how you exercise your options, the end effect is the same: you now own stock in the business, which may help you supplement your income beyond your normal salary.

Ready to bring your startup to the next level? Apply to MassLight’s next batch. MassLight supplies capital and a dedicated tech team. We take equity in return. Have questions? Refer to our FAQ page.

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