published February 23, 2021
Stock Options & Restricted Shares: How Early-Stage Startups Issue Equity to Employees
Especially as your startup is just getting off the ground, employee equity is an essential tool for attracting quality talent.
You may not be able to offer competitive salaries, but the potential for your company’s runaway success—whether that’s through acquisition or an IPO—is alluring to potential employees. And once they’re onboard, it gives them a stake in your long-term success.
Bringing in key employees can be critical to the success of your startup, and many top-notch employees simply won't take the risk to join your startup unless you give them a substantial equity grant as part of their compensation package.
Let's start with a broad overview of how to issue equity in the early stages of your startup.
Incorporating, issuing and giving equity
When your startup incorporates, you’ll set the number of authorized shares in your certificate of incorporation. After that, you’ll divide the authorized shares and issue them to employees and founders.
Issuing equity: Step by step
- Incorporate, and set the number of authorized shares. For tech startups, 10 or 15 million authorized shares is common. It’s better to have more shares than you need, for the sake of future issuances or to maintain founder control.
- Appoint your board of directors.
- Purchase founder shares. The total number of shares purchased by founders will be a percentage of total authorized shares.
- Usually, the board votes to set aside the remaining percentage of authorized shares, to be issued to employees, consultants, and advisors.
- When you want to issue shares to an individual, those shares are taken from the percentage of total authorized shares set aside by the board. Specifically, they’re issued as restricted stock.
What is restricted stock?
Restricted stock issued to employees vests over time. That creates an incentive for individuals holding on to stock to stay with your company.
When restricted stocks vest, it does so at fair market value (FMV). Until your company undergoes a 409A valuation—more on that shortly—it’s up to you and your board to set the FMV on shares.
At the time their restricted stocks vest, shareholders may either be granted the stock, or pay an exercise price to buy it. The gain in value you get from the stock, or the difference between the exercise price and the stock’s value, is called the spread. It’s what makes buying stock early in a startup’s growth attractive.
More info: Learn how vesting schedules work, and what they mean to you.
The fair market value (FMV) of shares
At the initial stages of a corporation, the founders purchase shares after incorporating at par value, and then the board sets aside a percentage of shares to issue to employees. Later, as people are willing to invest money—through SAFEs or convertible notes—you may need to change the price of shares to reflect these events. That means setting a fair market value.
Par value vs. fair market value
Think of par value as acting like an initial placeholder. After you first incorporate, the founders buy their shares, and the board sets aside a block of stock to issue to employees, that stock needs to have a value attached to it. For tax and accounting purposes, you can’t buy or sell stock worth $0.00. So, you assign a low, nominal value.
One common approach is to assign each share a value of $0.00001. If you authorized 10 million shares in your articles of incorporation, that would bring the total cost of your shares up to $100.
Want to take a closer look? Learn how to set your stock’s par value and FMV.
Anyone who owns shares in your company before you set an FMV will have a healthy interest in your shareholders’ value.
Simply put, your shareholders’ value consists of your company’s total assets, minus its liabilities. In the event of liquidation, these assets are split up among the shareholders. Your shareholders’ value is listed on your company’s balance sheet.
Moving from par value to fair market value
After you incorporate, you’ll develop intellectual property and raise money for your startup—typically by selling convertible notes or SAFEs at the early stages. This affects the value of your company, and that value needs to be reflected in the price of shares.
So, it’s time to set an FMV to replace par.
If you don’t set an FMV, you could raise alarms with the IRS and SEC, get audited, and potentially face penalties. That’s because, if your company has increased value, but your stock is still priced at par, you’re potentially selling stock for much less than it’s worth.
Setting fair market value
At this point, after issuing restricted stock but before undergoing a 409A valuation, you need to set an FMV; it will determine the price of the common stock. (The price of preferred stock will be valued by investors when a priced round is sold.)
To do this, you may turn to your accountant or legal counsel for help. One problem: They won’t give you a number.
Any FMV you set now is temporary—a stopgap until your 409A. The goal is to choose a number that won’t land you in trouble with the IRS, but without undervaluing your stock. If you ask a third party to set this number for you, they won’t do it. In their eyes, it’s too much of a liability.
Discussing fair market value with your lawyer
Here’s how you arrive at a fair market value with the help of your lawyer:
- Suggest a number
- Your lawyer says “hot” or “cold”
- Suggest another number
- Your lawyer says “hotter” or “colder”
- Repeat steps 3 and 4 until you’ve reached a very hot number
We’re not joking. This is how you do it.
Your lawyer won’t want to give you a hard number, for liability reasons. But they can advise you on it in a convoluted, indirect way.
Remember, your goal is not to land at a totally precise FMV. It’s to set an FMV that is defensible in case it ever becomes a subject of discussion between your company and the IRS.
Changing fair market value again
As you raise more money, you’ll need to adjust your FMV to reflect the changing value of your company. That probably means more meetings with your lawyer. Every time you set a new FMV, the board votes on it. Keep in mind, as soon as you raise a priced round, or sell any preferred shares, you need to get a proper 409A valuation done, and then get it reevaluated on an annual basis.
Preferred vs. common share prices
When you issue stock, you’ll issue two types: common shares, and preferred shares. Each type of share has its strengths. Most importantly, they’re priced differently based on FMV.
What are preferred vs. common shares?
In brief, common shares (or common stocks) allow their owners to vote in company decisions, such as electing a board of directors. True to their name, they’re the most common type of stock you’ll issue.
Preferred shares (or preferred stocks) also allow their owners to vote in company decisions. Preferred stock often carries a number of other rights that go above and beyond the rights given to the common shareholders, including:
- Co-sale rights
- Pro-rata rights
- Right of first refusal on shares for sale
- Full ratchet or other anti-dilution rights
- The right to elect members to the board of directors
Investors in your company—as opposed to employees—typically hold preferred shares. Investors may be able to vote alongside common shareholders, or as their own group. An investor who holds a lot of preferred shares may be granted a seat on your board.
How preferred and common stock are priced differently?
Because the corporate charter grants different powers and pays dividends and other distributions out differently, common and preferred shares are priced differently.
In the past—up until the early 2010s—common shares were steeply discounted; it was typical to find common shares priced at 10% of preferred.
Today, due to multiple SEC rulings, common stock can no longer be discounted as much as it once was. Common stock discounts applied by 409A valuations typically start at 20%, and no lower.
Also, as your startup goes through funding rounds, the discount that your 409A applies on common stocks decreases, because as you raise more money, the risk of your company failing decreases, and the price your investors pay comes closer and closer to what it would be worth if traded on an open market (i.e., its fair market value).
Issuing equity after a 409A
Typically, you’ll retain a company to perform a 409A valuation after raising a priced round. The way your startup issues equity will change after you receive a 409A.
What is a 409A?
A 409A valuation is a systematic determination of a company’s FMV, assigning a value to your company (and its common stock) that can be justified to the IRS.
While you can do this yourself, the best way to do this is to hire an outside adviser to complete the valuation. You give them information about your company, including income, number of customers, investments, and other data; taking that into account, they determine the value of the company.
Then, based on that value, they determine an FMV for your common stock.
An adviser is able to assign a value to your company and help you structure your stock offerings so you qualify for “safe harbor” with the IRS. This means the IRS must assume the validity of the 409A valuation, unless proven unreasonable.
While software options exist, you should seek a bona-fide third party for your 409A valuation. To reap the benefits of any safe harbor rule, you should have a qualified adviser perform the valuation. You can expect a 409A from an adviser to take about one month to complete.
From restricted shares to stock options after 409A
Once you’ve completed a 409A, you’re no longer legally allowed to issue restricted stock, but you can issue stock options to employees.
In some ways, stock options behave similarly to restricted stock—they also have a vesting period and restrictions on sale. However, by issuing options to your employees, you can delay the point at which those employees are taxed on the value of those options.
When you issue shares to an employee, they realize the full value of those shares as ordinary income. For example, you could issue shares to a new hire worth $10,000, and the employee would have to pay tax on that $10,000 as though it were added to their salary. However, since your company is private, and there is no reasonable secondary market for those shares, she cannot realistically sell them to recoup any of that cost.
Issuing options helps to delay these taxable events until there is a more easily accessible market for the underlying securities. Nonetheless, stock options do have implications; both ISOs and NSOs are treated differently, and there can also be implications based on early exercise of shares.
As you move towards issuing stock options, you’ll create a stock options pool for your employees. It’s up to you to decide the quantity of stock options each employee gets. Our guide to startup stock options pools has everything you need to get going.
Updating the 409A valuation
Your 409A valuation is good for 12 months. After that, you’ll need a new one. You may also need to get a new 409A if there are material changes to your company, such as a major investment, liquidity event, or a significant change to your revenues.
Capbase makes giving and issuing equity easier
Not only does Capbase give you an automated cap table to track ownership in your company, but we make it easy to set and reset an FMV. Sign up for Capbase to see how.
Learn how vesting schedules work for founders and employees at startups. Many startup founders have a 4 year vesting schedule with a 1 year cliff.
Should you grant your startup employees their stock options as ISO or NSO? Why do most early stage companies grant their employees equity options in the form of ISO instead of NSO? The answer: ISO have special tax advantages.