This article first appeared in the Union Leader in March 2021
Startups commonly face the predicament of needing to find unique ways to motivate and compensate key employees without using up limited cash flow. Where startups may not have the funds available to pay early employees market salaries, equity compensation can be an important recruiting and retention tool.
While federal and state wage and hour requirements still must be complied with, equity compensation serves as an incentive for the employees who are critical to growing the business and who will understand and value the opportunity to have a more direct stake in the company’s growth.
Stock options are the most common form of equity-based compensation for startups. An option is a contractual right to purchase equity at a fixed price during a specified period of time in the future. As the value of the equity increases, the employee’s option to purchase the equity is locked in at the value of the equity on the date the option is granted. Typically, options are subject to vesting, which incentivizes the employee to stay with the company until the option is fully vested. Until the option is exercised, the recipient of a stock option has no rights as a shareholder.
Generally speaking, employees are eligible for incentive stock options (ISOs); however, a number of requirements must be satisfied under the Internal Revenue Code in order to take advantage of the favorable tax treatment that ISOs provide. For example, the option’s exercise price cannot be less than fair market value when it is granted, which could require the company to obtain a valuation. If the necessary requirements are met, the employee would not owe any tax until the stock is sold (after the option is exercised), and then the difference between the exercise price and the sale price may be taxed as capital gains.
Another popular form of equity compensation is the grant or sale of restricted stock. Unlike with options, the employee would actually own equity in the company and may have voting rights. Restricted stock is typically subject to vesting and transfer restrictions. Additionally, the company usually has the option to repurchase the stock under certain circumstances, including termination of employment.
Restricted stock is most commonly issued shortly following the company’s formation, while the value of the stock is nominal. As the fair market value of the company’s stock increases, the tax impact can create an impediment to a company’s ability to sell or grant restricted stock to employees, as employees often do not have the cash to pay a significant tax bill on the shares of an illiquid, early-stage company that remain subject to vesting.
Section 83(b) of the Internal Revenue Code allows the recipient to pay income tax on the fair market value of the shares at the time of grant (when the stock presumably has nominal value), as opposed to when the shares are fully vested and likely worth more. In order to take advantage of this option, the recipient must file an 83(b) election within 30 days after the stock is granted.
Phantom stock and stock appreciation rights
As an alternative to issuing actual equity, startups can grant phantom stock, which affords employees with many of the benefits of stock ownership without actually issuing stock in the company. Phantom stock provides a contractual right to receive a cash bonus upon the occurrence of certain triggering events (such as the sale or change of control of the company), and the bonus is equivalent to what the employee would have received if they actually held stock in the company.
The phantom stock interest typically exists as long as the person is providing services to the company and terminates if the employee leaves before a change of control. The recipient of phantom stock does not owe any taxes unless a bonus is actually paid out, at which point income tax is paid on the amount received. Stock appreciation rights (SARs) are similar to phantom stock, but this incentive is structured so that the employee only gets the value of any increase in the equity’s value, starting on the date the incentive is granted, as opposed to receiving the full value of the underlying equity as well as any appreciation.
Stock options, restricted stock and phantom equity are all equity-based compensation choices for a startup looking to conserve limited cash (and for founders looking to retain control of their company) while attracting and retaining key talent. Moreover, equity compensation is a means of improving employee productivity and increasing the company’s overall value.
Emily B. Penaskovic is a corporate attorney at Cook, Little, Rosenblatt & Manson, where she advises entrepreneurial clients on a variety of business matters, including entity formation, capital raising, and equity compensation plans. Emily is also on the Board of Directors of the New Hampshire Tech Alliance and chairs NHTA’s Startup Committee. Emily can be reached at firstname.lastname@example.org.