Most early-stage companies can’t afford to pay market rate salaries to most of their employees. Unless you’re heavily funded, cash flow is tight, and, on salary alone, your company will never be able to compete with the likes of Google and Amazon. Luckily, you have virtually unlimited access to another tool: company equity.
Equity and equity options let you make competitive compensation offers to employees, allow them to buy shares in your startup, and incentivize new hires by allowing them to share in the upside of your company’s success (and rising stock price).
In this article you'll find information on:
- Difference between Restricted stock, RSUs, and stock options
- Incentive Stock Options (ISOs) vs Non-Qualifying Stock Options (NSOs)
- How to Plan for Employee Stock Tax Implications
Restricted Stock, Stock Options, RSUs and Tax Obligations
In addition to helping you close the wage gap, differing types of equity options allow you to leverage vesting to make your early hires more likely to stay for the long haul. Given a typical four year vesting schedule with a one-year cliff (ie. the period of time over which equity vests is four years, beginning after a one year waiting period), employees are incentivized to stay at least a year until their options mature. As a result, they don’t leave early, causing the loss of critical institutional knowledge from the company.
In all likelihood, your employees will be familiar with the typical compensation package for a startup and expect an equity offer from your startup and ESOP (Employee Stock Option Plan) offer letter as part of their startup employment agreement.
Even though cash compensation is only part of how startups pay their employees, remember that unlike contractors, you must compensate employees fairly and give them all benefits that your local labor and wage laws demand.
So what is an equity award? Although there are technically as many types of equity grants as corporate lawyers can dream up, there are only a few used in typical startup equity plans. Legally, equity grants are used to compensate founders and other employees, but are not intended to be used to pay or reward investors or service providers (though they sometimes are… don’t worry about this now).
There are 3 types of equity grants that are usually employed at early stage startups and make their way into your total equity picture along with shareholder equity and your own holdings (founders' common stock.)
Typically restricted stock is given early in the company life-cycle, before a 409a valuation, stock options are awarded after, and RSUs make their way into the process in later stage companies before (or after) an IPO—we’ll cover these in greater depth in a future article.
Because they may still seem so similar, it’s important to understand the place of the different grants in your overall equity plan and how they’ll play into your total pre-funding startup equity. I’ll outline the differences between the three components of stockholder equity in brief:
Restricted stock is somewhat similar to restricted options, but they are stocks. Restricted stock, sometimes called “restricted shares”, consist of a number of shares that have been granted to employees, frequently executives, and do come with all appropriate voting rights.
They usually come with a vesting schedule, which outlines when they can be sold, though their ownership transfers at the time of the grant or purchase.
Taxation on restricted stock will depend on their stock option grant price and occurs on the date they are exercised based on the difference between the FMV (Fair Market Value) and price at which the stock is granted to the employee. Restricted stock cannot typically be sold until a trigger event occurs, such as an acquisition or an initial public offering of the stock, unless the company explicitly authorizes the sale on secondary markets.
You must calculate the Alternative Minimum Tax (AMT) for restricted shares, and the gains will be taxed at either that or the income tax rate at the end of the calendar year in which they are exercised—whichever is higher.
It is possible to take the 83b election on restricted stock if you early exercise, in which case you won’t incur additional tax liability until their sale, which will be eligible for lower capital gains taxes if it is 2 years or more down the line from the issuance date.
Stock Options are, as they sound, options to purchase stock at pre-set price at a date determined in the stock grant. The stock is not issued until it is purchased—at or after the time set by their vesting schedule. Stock options have an expiration date, after which they cannot be exercised.
The strike price is set at the time of the issuance of the options. In the case that a company authorizes the early exercise of unvested stock options, they will be eligible for an 83(b) election.
Taxation on Stock Options is a little trickier, as there are two main types of option grants in use, Incentive Stock Options (ISOs) and Non-Qualifying Stock Options (NSOs).
ISOs or NSOs?
In the overwhelming number of cases, companies will use ISOs to compensate employees, because they come with a lower immediate tax obligation and are thus generally more appealing vehicles. While NSOs can be granted to contractors, consultants, and basically anyone, while, on the other hand, ISOs may only be awarded to employees. For an in-depth look at the differences between the two, read our article ISO vs. NSO: Which Are Better For Employees?
How Are ISOs Taxed?
Because employees with ISOs don’t need to pay taxes immediately upon exercising their options, ISOs are generally more tax-advantaged than NSOs. Those exercising ISOs only pay taxes when they sell their shares. If an employee keeps the shares until at least one full year after vesting and at least two years after the grant date, the gains qualify as capital gains instead of ordinary income. The good news is that ordinary or capital gains taxes aren’t due on ISOs until you file your taxes for the calendar year in which they’re sold.
For example, let’s say you’re granted 100 shares of incentive stock options on January 1, 2020, and the shares vest on January 1, 2021. If you exercise and hold the options on January 1, 2021, you will have to hold the shares for at least one year to qualify for the preferential capital gain tax treatment.
How Are NSOs Taxed?
NSOs are different. Regardless of whether you hold your stock options or sell them, the spread (the difference between the exercise price and grant price) is counted as part of your earned income and taxed at your ordinary income rate. NSOs taxes are withheld at the time of exercise.
This earned income is also subject to payroll taxes, which include Social Security and Medicare. Social Security payroll taxes are equal to 6.2 percent on earnings up to $137,700. If your earned income already exceeds this amount, then you’ll only pay taxes toward Medicare, which is 1.45 percent. However, if your earned income doesn’t exceed this amount, your gains will be subject to your ordinary income tax rate plus 7.65 percent to account for payroll taxes.
RSUs are not stock, nor are they options. RSUs (Restricted Stock Units) are similar to warrants, but do not expire and will always hold some notional value due to the fact that they are typically only issued at companies who have gone public or are about to.
Essentially, they are an agreement by a company to grant a certain amount of stock to an employee at a certain time. Until they have vested, the stock is unvalued, so it includes no voting rights and does not cause dilution.
Taxation on RSUs is simple and occurs once—when they vest. At that point they are declared and taxed as regular income and can either be sold immediately or held.
Once you’ve decided what kind of equity award to make to employees, you’ll issue them paperwork along with your offer letter, and they will need to complete certain forms like equity purchase agreements, restricted stock purchase agreements and the like, which are available in template form on Capbase.
How to Plan for Employee Stock Tax Implications
Regardless of whether you receive incentive stock options or non-qualified stock options, know that both are subject to taxes and need to be accounted for when you file. The most important thing to remember is that once you exercise your options, the result is the same—you now own stock in the company, and that stock can help you pad your financial future beyond your regular paycheck.
- Companies use equity compensation to incentivize employees to stay at the company and close the compensation gap between startup salaries and larger companies.
- Most companies use either Restricted Stock, Stock Options or RSUs to compensate employees with equity.
- Restricted Stock is typically given before a 409a valuation, Stock Options after and RSUs when an IPO is in sight.
- Many companies prefer to issue employees stock options in the form of ISOs rather than NSOs due to their tax advantages.
409A valuations are independent appraisals of a startup's common stock. Startups should use an independent, outside valuation firm to get a 409A valuation before offering stock options to employees to avoid fines and legal issues with the IRS.
Written by Stefan Nagey
Serial entrepreneur engineering & business leader who co-founded and led his last to a $14M Series A financing and a successful exit. Years of experience leading teams & building scaleable, secure software systems.
Issuing equity to employees in an LLC can be complex and require tax advice. Many startups prefer to incorporate as C Corporations because the process for issuing equity to employees is much simpler.