Employee Stock Compensation: Equity vs. Options

author avatar by Stefan Nagey • 8 min

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 are the tools that enable you to 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.

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 4 year vesting schedule with a one-year cliff, employees are incentivized to stay at least a year until their options mature, so 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 offer letter (Employee Stock Option Plan) as part of their startup employment agreement.

Even though cash compensation is only a portion 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).

Restricted Stock, Stock Options, RSUs and Tax Obligations

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.

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

Restricted stock is somewhat similar to restricted options, but they are stocks. Restricted stock, sometimes called “restricted shares”, are stocks 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

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.

Their 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 ISOs vs. NSOs: Which Are Better For Employees?

RSUs

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.

TL;DR:

  • 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.

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author avatar

Serial entrepreneur engineering & business leader who co-founded and led Dharma.ai to a $14M Series A financing. Years of experience leading teams & building scaleable, secure software systems.

DISCLOSURE: This article is intended for informational purposes only. It is not intended as nor should be taken as legal advice. If you need legal advice, you should consult an attorney in your geographic area. Capbase's Terms of Service apply to this and all articles posted on this website.