To give or not to give employee equity, that is the question. One of the first issues startups deal with is how they plan on compensating key personnel. For startups with limited funds, there may not be many options.
Aside from the traditional form of payment (i.e. cash), startups who form their entity as a corporation, have another avenue to compensate employees, advisors, or the like; stock equity. The want or need to issue equity really depends on your startup’s short and long term goals, as well as its financial capabilities.
What is Equity?
Equity refers to an ownership (voting) interest in a corporation, which comes in the form of a stock certificate. During various stages in a startup’s lifecycle, the startup will issue equity to founders, employees, investors, and others. Offering equity in a company is typically contingent upon several variables, such as the role an individual would play, and the time in which they joined.
Employee Equity Options for Startups?
The two basic types of stock are preferred stock and common stock. Each type of stock has its benefits, drawbacks, and will be used for different kinds of people.
Preferred stock refers to a certain type of equity, where certain shareholders possess a higher claim (preference) during the liquidation of stock than common shareholders.
Typical characteristics of preferred stock are:
- Holders of preferred stock typically have limited to no voting rights.
- Preferred stock receives a fixed dividend (if the company issues one) which has the ability to appreciate in price.
- Preferred stockholders have liquidation preference over common stockholders.
Though money collected from preferred stock is generally classified as taxable income, it is taxed differently than normal income. Excluding those in the highest tax bracket (i.e., investors), who pay around 20%, the majority of preferred stockholders pay only 15%, or nothing at all if their dividends qualify for specific tax treatments.
Common stock is the typical form of employee equity. Common stock is a voting interest in a company. Common stockholders typically have one vote per share of stock, unless there are different classes of common stock. Common stock, as mentioned above, typically take a back-seat to preferred shares during a liquidation event. There are generally two ways to provide common stock to employees:
Employees have the right or ability to buy the stock at a specific price, known as the exercise price. While “stock” is in the name, stock options aren’t actually stocks. They are options, that when exercised (purchased) become stock.
Let’s say a company named Counsel hires a UX designer named Mark. A few years ago, Mark purchased common stock at the exercise price of $0.25 per share, based on the fair market value when he started. After three years, the value of each share becomes $2.00. Once Mark gains the right to exercise his options, he will be able to acquire company stock at a fraction of its current value.
Stock Option Tax Implications
The type of stock one owns will determine the kind of tax they pay when they sell their shares. There are two basic kinds of stock options, non-qualified stock options (NSO), and incentive stock options (ISO). If NSOs are granted, the stockholder would need to pay taxes when they decide to exercise their options and later sell them.
For qualified (ISO), employees don’t need to report income when they are granted, or when they decide to exercise them. Those who are granted incentive stock options only need to report income once they decide to sell, and depending on if certain requirements are met, the taxes could range far below regular taxable income rates, which are between 0-23.8%.
Restricted stock refers to the right to own stock, but with predetermined restrictions. Restricted stock doesn’t “vest” until certain conditions are met, fully. These conditions could be fulfilling performance goals or sticking with the company for a specific period of time.
The taxes on a restricted stock is dependent on how it was acquired. If the stock was granted to an employee as opposed to it being purchased at the FMV (fair market value), the employee would need to pay taxes (which could be very expensive) when they decide to exercise the equity (vest).
Looking to Make the Best Decision For Your Startup?
For CEOs in search of guidance on finding the best method of employee compensation, consider hiring the startup lawyers at the Law Office of Elliott J. Brown. We offer several services focused on enhancing your business decision making to mitigate potential issues that could arise.
To learn more about our startup services, contact the Law Office of Elliott J. Brown today.
The Law Office of Elliott J. Brown is not an accounting or tax firm and does not offer tax advice. Please consult with your accountant or a CPA for tax advice and tax planning strategies.