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Tuesday
Apr072009

Equity Compensation Explained

Start-up technology companies often have difficulty recruiting and retaining talented employees. These companies need to attract high quality employees to build their businesses; however, they often lack the financial resources to offer their employees competitive salaries. One way to help level the compensation playing field between start-ups and established companies is with equity compensation.

Equity compensation is non-cash compensation that represents an ownership interest in the company. The two most common forms of equity compensation are stock options and restricted stock. Due to the variety of legal, accounting, and tax issues that are involved with equity compensation, proper planning is critical. Therefore, a company should seek legal and accounting advice before implementing an equity compensation plan.

A stock option is a right to purchase shares of a company’s stock at a predetermined price, which is referred to as the exercise price. The right to exercise the option and purchase shares of a company’s stock generally accrues, or "vests," over a period of time. The vesting of options over time creates an incentive for the employee to remain with the company to build its value. Option holders are not stockholders and thus are not entitled to vote their option shares or otherwise exercise any other rights of stockholders. All or a portion of the vesting of options often accelerates upon the sale of the company, unless the buyer assumes the options under its plan. Conversely, if an employee leaves the company, the vesting of stock options ceases, and the employee usually has a limited period of time to exercise the options that were vested on the employment termination date.

There are two types of stock options: incentive stock options ("ISOs") and non-qualified stock options ("NQSOs"). In the case of ISOs, and generally in the case of NQSOs, there is no tax to the option holder when the option is granted or when the option vests. The crucial distinction between ISOs and NQSOs is when the option is exercised. Generally, there is no tax to the option holder when ISOs are exercised. (However, the option holder may be subject to alternative minimum tax when ISOs are exercised.) When NQSOs are exercised, the option holder is subject to ordinary income tax on the difference between the exercise price and the fair market value of the stock on the date of exercise. The option holder is subject to capital gains tax on the sale of the stock that was purchased upon the exercise of ISOs and NQSOs. This tax is on the difference between the sales price and, in the case of ISOs the exercise price, and in the case of NQSOs the fair market value of the stock on the date of exercise.

Under the Internal Revenue Code, a stock option must satisfy several criteria to qualify as an ISO. Principal among these is that ISOs may be granted to employees only, and the exercise price of ISOs must be equal to or greater than the stock’s fair market value on the grant date. NQSOs may be granted to non-employees, such as outside directors or advisors. The exercise price of NQSOs may also be less than the stock’s fair market value on the grant date.

While stock options are appropriate for most employees, a company’s founders generally demand the voting and other rights of stockholders. However, the founders may desire to ensure that the stock owned by all of the founders is at risk and thus subject to forfeiture if a founder leaves the company. This motivates all the founders to work hard to build the company’s value, and if the stock of a departing founder is forfeited, it can be used to hire a replacement thus minimizing the dilution to the remaining founders. In addition, investors may wish to ensure that the founders are motivated to remain with the company to build its value. Restricted stock fulfills these objectives and is often used as a form of equity compensation for founders.

Unlike the grant of stock options, the grant of restricted stock is the issuance of shares of the company’s stock. A holder of restricted stock can vote the shares at stockholder meetings and has all of the other rights of a stockholder under applicable corporate law.

Restricted stock is generally subject to a repurchase right that allows the company to repurchase a portion of the founder’s stock if his or her employment is terminated by the company for cause, or if the founder voluntarily resigns within a certain period of time. This repurchase right lapses over time, freeing the stock of the restrictions in much the same way that stock options are subject to a vesting schedule.

The founder is subject to ordinary income tax as the restrictions lapse in an amount equal to difference between the purchase price of the shares and the fair market value of the stock at the time the repurchase restrictions lapse. However, the founder can file a "Section 83(b) Election" with the IRS within 30 days of the grant of the restricted stock to accelerate this tax to the grant date. If this election is made the founder is subject to ordinary income tax upon the grant of the restricted stock equal to the fair market value of the stock on the grant date. In either case, the founder is subject to capital gains tax when the stock is sold.

The two most common forms of equity compensation, stock options and restricted stock, serve similar, yet different, purposes in structuring a company’s compensation plan. Proper use of equity compensation is important in building a start-up company as it helps ensure the hiring, motivation, and retention of quality employees.

 

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