Startup Employee Equity Compensation
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Authored by Bryan Springmeyer Bryan Springmeyer is a California corporate attorney who represents startup companies. The information on this page should not be construed as legal advice. |
I’m often contacted by people who are evaluating employment offers for startups and are trying to figure the equity components of compensation. Assuming the company is funded and had counsel prepare their stock plan for employees, the equity component of the job offer is most likely stock options.
Stock Option Primer
Stock options are contractual rights to purchase stock at a certain price (“Exercise Price” or “Strike Price”). The right typically allows an employee to purchase an amount of stock based on the employee’s continued employment with the company.
Compensatory options are granted with a Strike Price equal to or above the fair market value of the underlying stock. The fair market value is often determined by an outside finance firm. Based on one of the more significant tax statutes, the valuations are typically referred to as 409A valuations. In tech startups, the fair market value of Common Stock determined for a 409A valuation is often considerably less than the price of Preferred Stock that investors pay. This is defensible because the instrument provided to investors has preferential treatment that justifies disparate valuations. Nevertheless, upon an exit which gives stockholders the ability to liquidate in the future (i.e. acquisition or IPO), the stock resulting from the exercised option will likely be valued above the Preferred Stock sold prior to the 409A valuation. In short, if an option grantee in a privately held startup gets the opportunity to liquidate after exercise, they’ll probably be doing it at a huge increase over the strike price.
On the flipside, an option grantee in a private company may not get the opportunity to liquidate. Unlike options in a public company, where a grantee can exercise and sell when the market price is above the exercise price (or can exercise ISOs and sell after the holding periods for long-term capital gains) options in a startup entail the risk that the stock resulting from the options exercise can never be sold.
This is especially relevant for an employee that is leaving a startup after spending several years there. Unlike restricted stock, which would give the departing employee vested stock, the employee that is given options has just that - vested options. Based on the terms of the plan, the employee will likely only have a short period of time after departure (usually 3 months as a function of IRC §422) to exercise their options. This means they will have to purchase the stock at the exercise price (unless the company allows them to use some of the options to pay the purchase price of the other options, a "cashless exercise") with no guarantee that they will ever be able to sell the stock, let alone at a profit. This may be easy if the strike price was very low, but if the employee must spend several thousand dollars to exercise their options, they must bear the risk that they will never be able to liquidate (at a profit).
What are the tax implications?
Company stock plans are usually set up to provide incentive stock options (ISOs) for employees. To qualify as an ISO, an option must meet the statutory requirements of IRC §422. The qualifications are based on:
- (A) The company’s compliance in designing the Stock Option Plan - the options were granted pursuant to a plan which:
- (i) identifies the total number of shares in the option pool;
- (ii) specifies the class(es) of employees eligible to receive options;
(iii) was approved by the stockholders within 12 months of adoption);
(iv) the terms of the Plan specify that the option is not exerciseable after 10 years from the grant date;
- (i) was issued within 10 years of the adoption of the Plan; (ii) the grantee owns less than 10% of the voting power of the company );
- (i) the stock is not sold until at least 2 years after the grant and 1 year after exercise, and
(ii) grantee remained an employee of the company at all times until 3 months before exercise.
If the qualifications are met for an ISO, the grantee may sell the stock acquired through the option and recognize the difference between the exercise price and sale price (“Spread”) as a capital gain.
If the statutory qualifications are not met, the options are “nonstatutory stock options” or “nonqualified stock options” (NSOs). The Spread on NSOs is recognized as income.
Related Pages:
Tax Issues for ISOs, NSOs, and Restricted Stock for Employees and Consultants
Stock Options or Restricted Stock?