Assessing how and when you should use equity to compensate your key team members involves a variety of sometimes complex considerations. In this article, we will review the follow:
When putting together a compensation package, in addition to salary and traditional benefits, equity compensation, like stock options and restricted stock, will typically be a factor for key employees and consultants. Early-stage and cash-lean companies may desire more attractive talent than they can afford, and equity compensation can help make up the difference. Companies of all sizes want to be able to reward exceptional performance and loyalty without committing to a higher salary upfront. Traditional stock options give the recipient the option to purchase a set amount of stock at some point in the future at a given price, but the recipient does not own the stock until the option is exercised. For the employee who wants to feel like they have a true ownership interest in the company, a stock option may not properly incentivize their performance. Restricted stock, however, may.
There are two forms of restricted stock: restricted stock awards (RSAs) and restricted stock units (RSUs).
Both your company’s Equity Compensation Plan, which provides guidance on the types of equity compensation that can be issued and the rights and responsibilities of the company and award recipients, and the individual award agreement will detail key definitions and provisions such as company repurchase rights, termination for cause, restrictive covenants, change of control, and transferability.
Your legal counsel can tailor the vesting schedule as needed to best fit your business strategy, but common vesting elements include:
Whatever you choose, it is essential that the vesting schedule is definable, achievable, and advances your business goals. The adage “you get what you pay for” rings true, here, so think carefully about what behaviors you want to encourage and reward and whether the schedule will motivate your chosen recipient.
Tax concerns in equity compensation should not be overlooked and your tax professional should weigh in on your company’s equity plan and any ancillary award agreements. The tax treatment options with RSAs and RSUs vary, so we will look at them individually.
RSAs and 83(b) Elections
Because the recipient of the RSA is paying a nominal amount for the shares, they do not owe taxes upfront unless they opt to make an 83(b) election within 30 days of the grant date. The 83(b) election allows the recipient to pay their taxes upfront on the difference between the strike price and FMV. Then, assuming they hold the stock for at least a year before selling, the increase in value at the time of selling is subject to capital gains rates, which in most cases is lower than ordinary income tax rates.
An 83(b) election can result in an increase in compensation to the recipient, but it is not without risk. In the case where the recipient has paid the taxes upfront but fails to either meet vesting conditions or the shares are otherwise repurchased by the company, and they front-loaded real tax payments on income that was only penciled-in.
Absent an 83(b) election, RSAs are taxed in the same manner as RSUs, as outlined below.
No 83(b) with RSUs
RSUs are taxed at two points: first, at ordinary income rates on the FMV of the stock when vested and second, at either capital gains rates or ordinary income rates (depending on the length of time you have held the stock) on the difference between the FMV and sale price when sold.
Your business stage and strategy should inform your choice, alongside the recipient’s performance goals. Along with consultation from your accountant and attorney, strategic considerations should include:
In the wake of a most uncertain year, companies in 2021 and beyond are looking more towards equity compensation as a way to bolster compensation packages while keeping salaries low. Conversely, employees may be wary of signing on for less certainty and may value higher salaries in lieu of worthless options. Restricted stock provides a bit of a balance between the two, giving your employees a sense of ownership and pride in their business and in many cases, short-term value that is tangible.
Developing a well-rounded and flexible Equity Compensation Plan with your legal counsel will keep you prepared for almost any eventuality and allow you to develop a compensation strategy that will motivate your team and take your company to the next level!
This blog was written by Hunter Business Law Attorney Haley Lemon.
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