Equity Grants & Start Ups

The following is an excerpt from The Start-Ups & Emerging Companies Guidebook, a preliminary discussion on best practices and strategies for start-ups and emerging companies to easily leverage.

You have a great idea for a new company and are ready to start the new venture.

Now what?

You need to bring on board the right people to make the company a success.

What’s next?

It will be a necessity to incentivize employees and other service providers in the long-term success of the company.

What compensation will you offer?

You have a myriad of action items, next steps and unforeseen challenges ahead of you.

What resources are available?

EQUITY GRANTS

Funds are typically at the lowest before the idea is launched into the economy, which results in many companies seeking a low up-front cost and a bigger incentive for the initial team of employees.  So, how do you bridge the gap between immediate out-of-pocket costs and giving equity in the company to new employees and consultants?

Enter into the equation – equity grants.

An equity grant is one way to bridge the gap between immediate compensation and long-term incentive compensation. An equity grant is a form of non-cash compensation to key individuals (employees and/or consultants) and can be granted pursuant to an equity plan and equity awards. These grants help keep individuals directly invested in the company’s success and align their incentives with that of the company. Depending on the type of entity your company is, the equity incentive plan can be a restricted stock plan, a stock option plan, a profits interest plan, or a phantom equity plan, or you can create an omnibus equity incentive plan, which can include multiple types of equity grants. Regardless of which plan you are going to adopt, it is necessary to reserve either a certain number of shares, or a certain percentage of the company, to be awarded to recipients of equity awards. In connection with an equity grant, a service provider receiving equity that is subject to vesting should be aware of a Section 83(b) election and the reference to Section 409A, which can invoke complex tax law implications in certain situations.  This article provides a high-level overview of some of the different types of equity grants that can be made to service providers and general concepts applicable to any grant.

GENERAL CONCEPTS

Restricted vs Unrestricted Equity

Generally, if equity is restricted, then it cannot be transferred until certain conditions are met. These can be time-based or performance-based conditions, which are set by the company. Vesting is the process by which the equity becomes unrestricted and is then owned freely (subject to any other restrictions the company has imposed on its equity) by the recipient of the equity. Oftentimes, the vesting process is tied to time intervals and has a cliff date that the company sets. A cliff date means that no equity vests until a certain date. A typical vesting schedule is a four-year vesting period, with a one-year cliff. Under this schedule, the first 25% of the equity grant vests and becomes unrestricted on the one-year anniversary of the grant date (the cliff date), and then the remaining 75% of the equity grant vests each month or each quarter until the fourth anniversary of the grant date at which point 100% of the equity grant has vested, and the previously restricted equity is now unrestricted. An unrestricted grant vests immediately and has no restrictions connected to the grant.

Section 409A

A company that is granting equity to its employees via an equity incentive plan should consider obtaining a 409A valuation. A 409A valuation is an appraisal of the fair market value of the company’s equity and ensures that the value associated with the equity grant is compliant with Section 409A of the tax code. Section 409A is a provision of the tax code that regulates deferred compensation and imposes tax penalties if certain requirements are not met. Deferred compensation, in the context of Section 409A, is broadly defined as any compensation that may be paid in a year following the year in which the right to payment arises. This can encompass employment agreements, performance plans, and certain equity award plans.

Section 83(b) Election

A Section 83(b) election is a provision under the tax code that gives a recipient of restricted equity the option to pay taxes on the income associated with the equity grant on the date of the grant as opposed to the vesting date, which can have vastly different outcomes depending on the value of the company at that time. The election form needs to be filed with the IRS within 30 days after the grant date, if the election is made. The amount of the income associated with the equity grant is the difference between the fair market value of the equity and the amount paid for the equity grant by the recipient on the date of the grant. If the value of the equity increases over time, the equity is sold more than one year after the grant date, the gain will be long term capital gain as opposed to ordinary income assuming the equity vests.

STOCK OPTIONS

Stock options grant the recipient the option to buy a set number of shares from the company at a predetermined price, once the options have vested. The price is known as the exercise price (or strike price) and is usually equal to the fair market value of the share on the grant date.  Holders of stock options will exercise the right to buy the underlying shares if the fair market value of the stock on the exercise date is higher than the exercise price (a/k/a “being in the money”). After the options have vested, they can be exercised at any time during the term of the option (which is normally ten years). Until the options are exercised, the holder of the stock option has no rights as a shareholder. The two types of stock options are non-qualified stock options, and incentive stock options. A key difference between non-qualified stock options and incentive stock options is that incentive stock options have a more favorable tax treatment for the employer, but as a result have many more rules attached to them including eligibility, holding periods, and restrictions on the exercisability of the options, a complete analysis of which is beyond the scope of this article. 

RESTRICTED STOCK AND RESTRICTED STOCK UNITS

Restricted stock is equity that is subject to certain restrictions until certain conditions are met. Restricted stock is actual stock so unlike stock options, the holder of restricted stock becomes the record owner of the shares of stock on the grant date and has all the rights associated with being the holder of stock, except for voting rights that might be limited by the company.

The equity is restricted in the sense that it is subject to forfeiture and is non-transferable until it vests. Additionally, vested restricted stock can have a repurchase right associated with it, giving the company the ability to repurchase the vested equity upon the termination of employment, for example.   

Restricted stock units are not actually restricted stock, but rather grants the service provider the right to receive equity in the company after the restricted stock unit vests. At that point, the holder of the restricted stock unit receives shares of stock in the company, and the value of that stock is treated as compensation. That distinction between restricted stock and restricted stock units is an important one that is sometimes overlooked.  

PROFITS INTEREST

A profits interest is an interest that gives a service provider of a partnership or limited liability company a percentage of the entity’s profits in exchange for contribution of services. These interests may or may not have any voting rights but give the recipient financial compensation that is tied to the performance of the company. Similar to other types of equity compensation, a profits interest can be subject to vesting over a certain time frame and other restrictions or hurdles before becoming effective. For example, profits interests can be structured so that they provide for payment to the holder of the interest only upon a liquidation event of the company.

PHANTOM EQUITY

Phantom equity is a type of compensation that promises to pay an amount in the future that is equal to a certain number of shares or units of the company. Companies will create a phantom equity plan in part because they allow a private company to incentivize service providers to be aligned with the owners (without being owners). A phantom equity plan provides for a cash payment to the service provider upon the occurrence of certain events, but they are not an equity holder. The phantom equity award agreement details the vesting schedule, number of shares or units, form of payment, and the trigger event that causes the commencement of payments.  The grantee is not an equity holder for any purpose, does not receive rights that an equity holder does, and would be taxed at ordinary income rates with respect to payments due upon a trigger event under a phantom equity plan in the future based on the terms of the plan.

SUMMARY OF EQUITY COMPENSATION

There are a number of different ways to provide compensation to employees and/or service providers other than paying them cash. As with most issues pertaining to structuring a business, the best type of compensation plan for you to adopt depends on the type of entity at issue and the ultimate goals for the company. It is important to remember that there are adverse tax consequences if the plans are not structured the right way, many of which cannot be reversed after the fact – making it essential that you have sought the proper legal and tax planning advice before beginning any plan.