Employees have the power to make or break your business. This is especially true in the world of startups, where so many companies rely heavily on their workers to provide services, develop software and provide value.
To bring the right employees to your business, you’ll need to offer attractive compensation packages. And in the modern world, that almost always includes some form of equity-based compensation.
Stock incentives are more popular than ever, and will only become more expected as employers compete for the best talent in their race to the top.
That’s why you need to understand how to incorporate equity into your key employees’ payment plans. This article will show you how.
Let’s get started.
Why Offer Equity-Based Compensation?
First, the fundamental question: if all you’re after is attracting talented workers to your firm, why not simply offer competitive traditional salaries?
The simple answer is that competing on salary alone is much more expensive from a cash flow perspective, and startups are often relatively strapped for cash in their early years.
If you’re a new startup (or are facing a decline in revenues due to the pandemic), then you may be unable to afford a high enough salary for all of your most valuable employees.
And there are other reasons why equity compensation can be beneficial for both parties involved.
The employer gets to:
- Save cash upfront when revenues might be limited
- Align the employee’s goals with the company’s goals (equities are only valuable if the company does well)
- Encourage loyalty over an extended period (equity compensation often vests over several years)
Meanwhile, if the company is successful, employees are given a chance at an exponentially larger payout down the road.
Now, let’s take a look at the most common forms of equity compensation and how they work.
The Common Forms of Equity-Based Compensation
There are three commonly used forms of equity-based compensation. Each has unique mechanics, advantages and taxation rules.
They’re all useful in different scenarios, and having the flexibility of multiple options can help you create an equity-based compensation plan that suits your company’s philosophy and financial situation.
Let’s start with the most popular.
Stock options allow employees to purchase company stock for a set price (called the strike price) once their interests have vested. This is usually over one to five years, which helps encourage longer tenures at the company.
The hope for both the business and the employee is that as the company grows, the value of the stock does as well. Once the employee’s interest has vested, they can then exercise their rights to purchase that stock at a large discount.
Stock options come in two forms, which we’ll examine below.
Non-Qualified Stock Options
Non-qualified stock options are the default form of stock options. They get their name from the fact that they don’t qualify for any special tax treatment.
Though there is no taxable event when the options are issued to the employee, taxes will be immediately incurred at the exercise date. Any difference in value between the strike price and the value of the shares on that date is taxed as ordinary income.
Additionally, when the individual wishes to liquidate their stock, they must follow the usual capital gains tax rules: if they hold the stock for more than a year, they’ll pay the cheaper long-term capital gain rates. Otherwise, they’ll pay the more expensive ordinary income tax on any gains.
Incentive Stock Options
Incentive stock options (ISO) follow the same mechanics as non-qualified stock options, but employees can avoid a big portion of the taxes if they play their cards right.
Exercising an ISO does not immediately trigger a taxable event. So long as the employee then holds the stocks for a year (thereby also qualifying for long-term capital gain treatment), they can avoid any taxation on the difference in value between the strike price and the underlying stock price.
Restricted stock compensation also vests over time, but does away with the option mechanics. There is no strike price and nothing to exercise. The only real limitations are the vesting periods.
Restricted Stock Units
Restricted stock units (RSU) are essentially an “I owe you.” As the vesting periods pass, the employee exchanges their RSUs for an equivalent number of shares at no cost.
However, it will be taxed as ordinary income and added to their W-2 wages at fair market value.
For example, an employee whose 200 RSUs vest in a given year receives 200 shares of company stock at $50 each. Those 200 shares at $50 each translate to $10,000 of additional taxable income for the year.
Of course, the employee then has the option to sell the shares at will, subject to the usual capital gain tax rules.
Restricted Stock Awards
One of the limitations of an RSU is that employees don’t have any shareholder rights until after their vesting periods. Restricted Stock Awards bypass this issue by granting employees the shares upfront.
That means they’ll benefit from any dividends and be able to vote on shareholder matters from the beginning of their employment. However, they’ll still need to wait until their interests have vested to sell off their shares and realize any gains.
Employee Stock Purchase Plans (ESPPs)
Employee Stock Purchase Plans give employees the opportunity to purchase stock at a discounted rate, sometimes even as low as 85% of fair market value.
Employees can contribute to the plan via additional payroll deductions starting on the offer date and ending with the scheduled purchase date (usually around 6 months).
At the end of that offer period, the employer uses the accumulated contributions to buy stocks on behalf of their employee at the discounted rate.
There’s no vesting period for those shares, and the employee can turn around and sell their shares immediately after purchase if they want to.
However, there are some limitations:
- The IRS limits contributions for each employee to no more than $25,000 per calendar year.
- New employees are often unable to participate until after their first year of employment.
- To qualify for advantageous tax treatment, employees need to adhere to strict rules when selling their shares.
Non-Qualified vs Qualified ESPPs
To qualify for the better tax treatment, ESPP issuers need to jump through a few hoops:
- Company shareholders must approve the plan.
- The offering period must be less than three years.
- The discount rate can’t exceed 15% of the market value.
Additionally, employees need to meet certain holding period requirements to qualify. They can’t sell until:
- Two years after the beginning of the offering period
- One year after the purchase date
If employees do qualify, their original discount is taxed at ordinary income rates, while the subsequent gains are only subject to long-term capital gain rates. Non-qualified ESPPs or sales of the stock will cause both the discount and the gains to be taxed at ordinary income rates.
Choosing a Form of Compensation
Formulating an equity-based compensation plan for your employees is a complicated process. Paying legal fees, navigating regulations and analyzing the tax implications create friction from the start.
You also need to address some philosophical questions.
What percentage of your company are you willing to give up? Equity compensation can erode your control over your company and even dilute the value of shares.
How standardized do you want your compensation packages to be? Tailoring each equity package to each new hire can be a lot of work, but every employee’s value is different and one size probably won’t fit all.
But in the end, attracting and retaining the right talent for your company is worth the hassle.
And if you’d like additional guidance navigating the accounting and tax rules of equity compensation, Founder’s CPA is here to help. Feel free to take advantage of our free consultation.