To attract and retain top talent, equity compensation is not an option. It’s a necessity. That’s why it’s a good idea for founders of early stage companies and prospective employees to compare all of their options. Here’s an overview of some of the most common ones.
An Incentive Stock Option or ISO is a benefit that allows eligible employees to purchase company stock at a discounted price while enjoying favorable tax treatment. The taxes on ISOs are deferred until shares are sold and if an employee meets certain requirements, they’re only subject to capital gains taxes. ISO feature three critical dates, including:
- Grant Date: The grant date is the date in which the shares are allocated. It’s also the date the shares are valued normally and determined by the exercise price.
- Vesting Date: The vesting date is when an ISO becomes available to employees. While some plans have a set date when all of the incentive stock options must be vested, others allow a certain number of shares to be distributed over a certain time period.
- Expiration Date: The expiration date is the final date employees can purchase shares. If an employee doesn’t purchase shares by this date, they may miss an opportunity for additional income.
Since employees who wish to capitalize on ISOs must hold on to them for a set period of time, they will need to stay with the startup for a while. The higher the company’s share price is, the greater their reward will be. ISOs are a great way to encourage productivity and motivate employees to commit to a company.
It’s important to note that ISOs are non-transferrable, unless the owner passes away. Also, employees can only receive $100,000 worth of ISOs each calendar year. In addition, those who retain at least 10% of the startup are required to pay a premium for exercising.
AMT Implications on ISO’s
Alternative minimum tax or AMT ensures that certain high-earning taxpayers pay at least a minimum amount of income tax. It requires ISO taxpayers to report the profit difference between the price they paid for the stock and the market price when it’s sold. This difference is referred to as the “bargain element.” After a specific amount of “profit” or ATM threshold, employees must pay taxes. Anything below this threshold, however, is tax-free.
A Non-Qualified Stock Option is a stock option without the restrictions of an ISO. It may be granted to a variety of parties, including employees, consultants, contractors, directors, and vendors. Plus it may or may not include a vesting schedule and there is no limit on the value of NSO that can be distributed in a year.
When it comes to taxes, NSOs are not eligible for the same special tax treatment as ISOs. Instead, they’re taxed at the ordinary income tax rate when someone exercises and when they share the shares. In addition, NSOs are transferable per the original agreement.
A Restricted Stock Unit or RSU is a stock share award that’s typically given as a form of employee compensation. In most cases, RSUs are distributed through a vesting plan and distribution schedule after an individual meets certain performance milestones or stays with the company for a specific length of time.
While RSUs give employees interest in employer equity, they don’t have tangible value until they’re vested. When they vest, they’re assigned a fair market value (FMV). At this point, they’re considered income and the portion of the shares is withheld to pay income taxes. Then, the employee receives the remaining shares and may sell or hold onto them.
RSUs incentivize employees to stay with a company for the long haul and help it succeed so that the shares increase in value. They come with minimal administration costs as there are no actual shares to track and record. In addition, RSUs give a company the opportunity to defer issuing shares until the vesting schedule is complete, delaying their dilution.
An employee stock ownership plan (ESOP) is a tax-advantaged retirement plan that provides employees with ownership interest in the company through shares of stock. Unlike other types of retirement accounts such as 401ks, the company usually funds the benefit so employees don’t have to contribute on their own.
There are a few ways an ESOP can be arranged. Ownership may depend on pay compared to other employees or tenure at the company. Oftentimes, there’s also a vesting schedule, in which ESOP membership is based on how long an individual has worked at the company.
For example, they may be required to work there for three to five years before they can unlock all of the ESOP benefits. In general, ESOPs are used by privately held companies rather than public companies. The owners may design an ESOP when they’re ready to sell or retire the business.
Vesting Schedules & Standard Vesting Schedules
A vesting schedule refers to a schedule of how an employee earns the right to their startup equity over a period of time. This allows employers to reward loyal employees who stay with their company for a long time. The three main types of vesting schedules include:
- Time-Based Vesting: In a time-based vesting schedule, employees earn a percentage of stock options over time, based on a cliff or schedule. A cliff is the time an employee must work before they vest any stock at all. The standard in startups tends to be four year monthly or quarterly vesting, with a one year cliff. This ensures employees are willing to stay for at least a year before they can leave the company as a shareholder.
- Milestone-Based Vesting: This refers to a vesting method in which stock options and benefits are based on the performance and achievement of particular milestones.
- Hybrid Vesting: Hybrid vesting combines milestone-based and time-based vesting. It states that employees must stay with the company for a certain period of time and achieve certain milestones.
Under the 83(b) election provision outlined in the Internal Revenue Code (IRC), employees, executives or startup founders can choose to pay taxes on the total fair market value of restricted stock at the time it’s granted to them.
If they file an 83(b) election form and pay nothing for their shares, the ordinary tax rate will be applied to their value when they’re granted. On the other hand, if they don’t file an 83(b) election form, the ordinary tax rate will be applied to the value of their shares when they vest.
Employees who wish to stay with their company for a while or expect the value of their company shares to grow over time may find the 83(b) election worthwhile. But if they have plans to leave their company in the near future or the value of shares is likely to decrease, going this route may cause them to pay unnecessary taxes without owning the shares.
Employee Option Pool
Also known as an employee stock option pool, an employee option pool is equity that’s specifically reserved for employees. When a company is ready to hire, they may decide to create an option pool. Its value is based on the per share value of the common stock, as determined by the most recent 409A valuation.
Typically, the shares in an option pool are distributed to employees based on seniority and date of employment. All details, like strike price and vesting period are outlined in the stock option plan documents. An employee option pool can encourage employees to join a startup and reward them when they do.
While offering stock options to employees might be expensive, it eliminates the need for a startup to pay out additional cash. Stock options give startups the chance to attract talent and grow without causing cash flow issues.
Creating an option pool will naturally lead to dilution. This is because the other equity holders must have their total stake reduced to meet the new equity. The dilution can be calculated using pre-money valuation or post-money valuation. Pre-money valuation means the dilution affects the founders and existing investors. If the employee option pool comes from post-money valuation, new investors would be diluted as well.
Not all startups are created equal. That’s why the type of startup equity that’s right for one company depends on their unique goals and preferences. If they learn about all their options and weigh the pros and cons of each, they can hone in on the ideal solution.