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Restricted Stock VS. Options for Key Employees of a Crowdfunding or Fintech Business

Mark Roderick Explains Restricted Stock VS. Options for Key Employees of a Crowdfunding or Fintech Business

You want to reward and incentivize your CFO and CMO with equity in the company. What’s the best approach?

First, make sure equity provides the right incentives. For the CFO almost certainly, because the CFO shares responsibility for the profitability of the whole company. For the CMO, maybe not. If we want the CMO focused on sales, maybe a cash commission makes more sense. On the other hand, you might decide that owning stock will have a positive psychological effect for your CMO, even if it doesn’t offer a direct incentive.

With that box checked, these are the most common equity-flavored alternatives:

  • Restricted Stock: The CFO might receive a total of 100 shares of stock today, with her right to receive distributions and otherwise enjoy the full benefits of the stock subject to a vesting schedule. The vesting schedule might be based on time (g., 20 shares per year for five years), economic milestones (e.g., 20 shares for each year showing a growth of at least 20% in cash flow or EBITDA), or a combination of the two.
  • Stock Options: The CFO might be granted the option to purchase 100 shares of stock for $0.10 per share (hoping they will someday be worth a lot more), subject to the same vesting schedule. Under section 409A of the tax code, that $0.10 per share exercise price must be the true fair market value at the date of grant, not an artificially low number.
  • Incentive Stock Options: If the company is a corporation (not an LLC) and satisfies lots of special rules, the CFO might be granted a special kind of stock option, with special tax benefits.
  • Phantom Stock: Rather than actual stock, the CFO might receive a contract right intended to achieve the same economic result.

In the world of entrepreneurs generally and the Fintech and Crowdfunding worlds specifically, restricted stock and stock options are the most common choices, so I’m going to focus on those today.

Economically, restricted stock and stock options are almost identical. But the tax consequences can be quite different. For purposes of the discussion below, I’m assuming (i) the CFO’s 100 shares are worth $0.10 per share today and increase in value at the rate of $1.00 per share per year, (ii) the CFO is given 10 years in which to exercise the options, and (iii) the company is sold in 10 years.

Scenario #1: Direct Stock Issuance – General Rule

If the CFO receives 100 shares today, vesting over five years, then she has zero taxable income today because no shares have vested. At the end of the first year she has $22 of taxable income (20 shares vested @$1.10 value per share), at the end of the second year he has $42 of taxable income (20 additional shares vested @$2.10 value per share), and so on. The employee must pay tax on this income each year, while the company can claim a corresponding tax deduction. Thus, over the duration of the vesting period the CFO pays tax on $310 of taxable income and the company obtains a $310 tax deduction.

In this example the CFO will pay roughly $100 of tax on his $310 of taxable income (depending on tax bracket, state of residence, etc.). The exact amount of the tax isn’t important. What’s important is that (i) she will have to fund this cost from her own pocket, and (ii) if the company is very valuable or she owns a lot of stock, her out-of-pocket tax cost could be prohibitively high.

When the company is sold after 10 years, the CFO will receive $1,010 for her shares and have $700 of gain. This $700 would be taxed at long term capital gain rates, and at that point she’ll have the cash to pay her tax.

Scenario #2:  Direct Stock Issuance Followed by §83(b) Election

Where an employee receives stock subject to a vesting schedule, §83(b) of the tax code permits an employee to elect to report as taxable income the entire current value of the stock. Having made the election, the employee does not report any additional taxable income as the stock vests.

In our example, the CFO could make an election and report $10 of taxable income on the date of grant (100 shares of the @ $0.10 per share). She would then have no additional taxable income as the stock vests, and the company would have no tax deductions. Upon the sale of her stock the employee would have $1,000 of income, taxed at long term capital gain rates.

An election under §83(b) must be filed with the Internal Revenue Service within 30 days after the CFO receives the stock.

NOTE:  Suppose the company fails after two years. Now the CFO has paid tax on $10 and has nothing to show for it except a $10 capital loss. That’s the downside of section 83(b).

Scenario #3: Options

The CFO recognizes no current taxable income as a result of receiving options. Instead, she recognizes taxable income as the options are exercised, equal to the difference between the exercise price of $0.10 per share and the value of the stock at the time.

In the simplest scenario, where the CFO exercises options to purchase 20 shares each year, the tax effect would be almost identical to Scenario #1 above. The CFRO would recognize $20 of taxable income in the first year, $40 the next year, and so forth, for a total of $300 of taxable income. No §83(b) election is available with options.

A more likely scenario is that the CFO wouldn’t (or wouldn’t be allowed to) exercise the options each year, but rather waits to exercise until the company is sold. In this case she would recognize no taxable income until sale, and at that point would recognize $1,000 of taxable income, taxed at ordinary income rates rather than capital gain rates. The company would be entitled to a corresponding deduction of $1,000. Again, the CFO would have plenty of money to pay the tax.

Conclusion

Options are simpler than restricted stock, especially if they can’t be exercised until an exit. And the holder of an option, unlike the holder of actual stock, has no right to see confidential information that the company would prefer to keep private.

For that reason, options typically make more sense from the company’s viewpoint, even though the employee might end up paying more tax (ordinary income vs. capital gains) overall. But every company and every situation is different.

Questions? Let me know.

Options Or Profits Interests For Key Employees of LLCs?

Co-Authored By: Steve Poulathas & Mark Roderick

You own an LLC and want to compensate key contributors with some kind of equity. Do you give them an equity interest in the Company today or an option acquire an equity interest in the future?

Before we get to that question:

  • Make sure that equity is the right answer for this particular employee. It’s great for key contributors to have a stake in the company, but if this particular employee is your CMO, a cash commission on sales might make more sense because it provides a more targeted incentive.
  • Make sure you’re giving the employee equity in the right business unit. If you operate a Crowdfunding platform, for example, and want to incentivize an IT guy, maybe the IT should be held in a separate entity and licensed to the operating company.
  • To dispel some confusion, a limited liability company can issue options. In fact, here’s a Stock Incentive Plan drafted for a limited liability company. The only thing a limited liability company can’t do is offer “incentive stock options,” otherwise known as ISOs, which provide special tax benefits to employees but are also subject to lots of rules.

Okay, equity is the right answer for this particular employee and you’re giving her equity in the right company. Now, what kind of equity?

There are lots of flavors of equity. These are the three you’re most likely to consider:

  • Outright Grant of Equity: Your employee will become a full owner right away, sharing in the current value of the business, possibly subject to a vesting period.
  • Profits Interest: Your employee will become a full owner right away, but economically will share only in the future appreciation of the Company, not the current value.
  • Option: Your employee won’t become an owner right away, but will have the right to buy an interest in the future based on today’s value – again allowing her to share in future appreciation but not current value.

In making your choice, there are three primary factors:

  • Economics: How much value are you trying to transfer to your employee, and when?
  • Messiness of Ownership Interests: If your employee becomes an owner of the business, even an owner subject to vesting and/or an owner whose economic rights are limited to future appreciation, you have to treat her as an owner. You have to give her information, you have to return her email when she asks (as an owner) why your salary is so high and why your husband is on the payroll, you have to send her a K-1 every year, and so forth.
  • Taxes: For better or worse (mostly worse), tax considerations are the principal driver behind many executive compensation decisions, a great example of the tail wagging the dog. If you thought the JOBS Act was hard to follow, take a look at section 409A of the Internal Revenue Code!

So here’s where we come out.

An outright grant of equity might be a good choice for a real startup assembling a team to get off the ground, as long as there is little or no value. By definition the founder isn’t giving up much economically, and the outright grant achieves a great tax result for the employee, namely capital gain rates on exit. The main downside is that the employee is a real owner, entitled to information, etc. But that’s not the end of the world, especially if the employee is in the nature of a co-founder.

(If your company already has value, then you’re giving something away, by definition, and your employee has to pay tax.)

A profits interest is just like an outright grant except for the economics:  there is no immediate transfer of value. But the tax treatment is the same (no deduction for the company, capital gain at exit for the employee) and the employee is a full owner right away.

An option is economically very similar to a profits interest, because the employee shares only in future appreciation, not current value (for tax reasons, the option exercise price can’t be lower than the current value). But otherwise they’re the opposite. The employee isn’t treated as an owner until she exercises the option. And upon exercise, she recognizes ordinary income, not capital gain, while the company gets a deduction.

For a company with just a few key contributors a profits interest isn’t bad. You give your employees a great tax result and what the heck, what are a few more owners among close friends? But for a company with more than a few key contributors the option is better only because it’s so much easier to keep a tighter cap table. And while the tax treatment of the employee isn’t as favorable, I’ve never seen an employee refuse an option for that reason.

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