Fundamentals of Equity Compensation

Congratulations, you’ve landed the job, got a promotion or have been offered a bonus! Only, your offer or bonus letter contains an equity package. You may know enough to know that means you’ll own stock in the company but what exactly is equity and what do you need to know about it before you accept it? Read on to learn the fundamentals of equity compensation and be sure to check the related article listed below for more information.

What is Equity Compensation?

Many tech companies offer employees compensation packages comprised of both a cash salary and equity, with equity often in lieu of a higher salary. Equity compensation is the right to own a specified portion of the company. Accepting equity in lieu of a higher salary is, in a way, betting on the company’s success. You are taking a gamble that your equity will gain value over the course of your employment greater than the increased salary you could have received. Let’s back up a second, though, to make sure we’ve got the basics down. The vast majority of companies in the tech world are organized as C-corporations and are owned by stockholders (sometimes called shareholders) who own stock (or shares) in the company.¹ This stock, as well as the right to purchase stock, is collectively called “equity.” So when you receive compensation in the form of equity, you are really receiving ownership rights in the company. Owners, i.e. Stockholders, have certain rights under the law, such as the right to participate in major management decisions and, perhaps most importantly, the right to share in any profits that the company distributes. Once you have purchased the stock underlying your equity award and satisfied any vesting conditions (see discussion below), you too will have the rights associated with being a stockholder. Not only is equity a form of compensation, but it is also an incentive for employees to work hard and stay with the company. As we will discuss in more detail below, equity awards are generally earned over time, a function known as vesting. Because of this built in schedule, as well as the fact that you are betting on the success of the company in order to reap the benefits of stock ownership, the equity award functions as an incentive for you to continue to work hard for the company.

Types of Equity

Equity compensation comes in several forms, the most common of which are stock and options. The fundamental difference between the two is that the recipient of a stock grant owns the stock immediately, whereas the recipient of options has the right to purchase stock at a pre-determined price, but is not yet a stockholder. Let’s look at each of these forms in more detail.

Stock

When a company sells stock, the purchaser becomes the owner of stock and thus a stockholder. A company may designate and sell different classes of stock, the most typical of which are Common Stock and Preferred Stock. Common Stock is the most basic form of stock and is usually held by current and former employees, contractors, advisors and directors. Preferred Stock, on the other hand, is generally reserved for investors, strategic partners and financial institutions. Depending on the stage of a company, it may have several series of Preferred Stock named in accordance with each completed funding round (i.e. Series Seed Stock, Series A Stock, Series B Stock and so on). ² While the law provides certain rights to all stockholders, Preferred Stock also carries special negotiated rights that are not applicable to the Common Stock.³ Companies generally only grant stock to employees at a very early stage – sometime between incorporation and the first funding round or major company milestone. The company may either grant common stock in exchange for services or sell common stock in exchange for cash or something else of value. When an employee receives a stock grant for services, the full value of the grant is taxable as ordinary income. When the stock is paid for with cash, on the other hand, tax is payable on the difference between the price of the stock and the fair market value of the stock on the day it is purchased. As stock must be purchased within 30 days of the company’s approval of the sale, this difference is usually zero. However, be aware that grants subject to vesting are taxed differently (see discussion on vesting below).

Options

An option represents the right to purchase a certain number of shares of stock at a locked-in, pre-determined price (the “exercise price” or “strike price”). The exercise price must be equal to or greater than the “fair market value” of the stock on the day the company approves the grant. “Fair market value” is the price that a reasonable person would pay for the stock as determined by either the public markets or the company (see article on valuing your stock that follows). Purchasing some or all of the stock underlying an option at the strike price, is referred to as “exercising” the option. Option grants come in two types, incentive stock options (“ISOs”) and non-statutory options or non-qualified stock options (“NSOs” or “NQSOs”). Only an employee can receive an ISO, whereas anyone who provides services to the company can receive an NSO. The other main difference between ISOs and NSOs is the preferential tax treatment given to ISOs. This chart breaks down the tax treatment of each type of option:

TAX TREATMENT OF ISOs v. NSOs

	ISO	NSO
Tax Implications on Exercise*	Exercising a valid** ISO does not result in any taxable income, unless the employee is subject to Alternative Minimum Tax (“AMT”).	Exercising an NSO results in ordinary income equal to the difference between the fair market value of the stock on the date of exercise and the exercise price (the “spread”). This recognized income is also subject to income tax withholding and employment taxes.
Tax Implications on Sale of Stock	When the stock underlying an ISO is sold, the difference between the selling price and the option exercise price is taxed as capital gain.	If the stock is held for 1 year from the date of exercise and 2 years from the date of the option grant, then the profit is taxed as long-term capital gain.

*Note: this assumes exercise of vested shares only. See discussion below for tax implications of exercising unvested shares. **Note: certain other restrictions apply to ISOs, which the company should make sure are complied with. Failure to comply with these restrictions results in loss of ISO status.

Restricted Stock Units

Restricted Stock Units (“RSUs”) are an agreement by the Company to issue the employee shares according to a vesting schedule. Each time the employee vests in shares, the Company will grant those shares. The employee is then required to pay ordinary income tax on the current value of the granted shares. RSUs are largely used by public companies and more established companies with higher valuations. When the shares underlying an RSU vest, the company may withhold a portion of the shares to pay for the necessary taxes. Otherwise, if the Company is public, an employee may chose to immediately sell a portion of the shares to cover the tax liability.

Units

A small number of start-up companies are organized as Limited Liability Companies, or LLCs. These companies issue units rather than stock or options. LLCs are fairly rare in the tech world these days, particularly ones that are, or strive to be, venture backed, so you’re unlikely to encounter this type of equity. However, if you are offered employment and equity in an LLC, be sure to ask for a detailed explanation of how the units are structured or even better ask for a copy of the LLC Agreement, which will detail all the rights and restrictions on units. LLCs do not have to abide by the same rules that a traditional C-Corporation must follow and no two LLCs structure units the same. Be sure to do your due diligence before accepting an offer that includes a unit grant from an LLC.

Summary

So why do you care what kind of grant you get? Do these distinctions really make a difference? Is one type of equity inherently better than another? There is no quick answer to these questions, rather it’s a function of your and the company’s current status. Early stage companies may have no choice other than to issue you stock directly. However, the stock should be relatively inexpensive in an early stage company and shouldn’t pose a cash flow problem for you. Alternatively, if you are receiving the stock as compensation for services, the total value of the stock will likely be low enough that the taxes imposed on the income won’t be large. Additionally, one benefit to receiving a stock grant outright is that the clock for long-term capital gain tax treatment upon sale of the stock starts right away. After the company has raised money or hit a major milestone and has obtained an independent valuation of its common stock, the company will likely only issue options to employees. Then the question becomes whether you want an ISO or an NSO. If you answer no to any of the following questions, you will want an ISO grant, if you answer yes to all of them, then an NSO is probably best:

1. IS THE GRANT EARLY EXERCISABLE?

-   If the grant is *not* early exercisable you want an ISO. Once the grant vests and you are eligible to exercise there will likely be a spread between your option price and the fair market value. If you hold an NSO, you will have to pay taxes on this spread.

1. DO YOU HAVE THE CASH FLOW TO PURCHASE ALL OF THE SHARES IMMEDIATELY?

-   Assuming you can purchase all of the stock (vested and unvested) at the time of grant, you'll need to make sure you have the necessary funds to do so. If so, you will have no immediate tax liability since there will be no spread between your option price and the fair market value. Additionally if you have an NSO, the holding period for long-term capital gain will begin right away.

1. ARE YOU SUBJECT TO ALTERNATIVE MINIMUM TAX (AMT)?

-   Depending on the state your in, you generally do not pay AMT unless you have income greater than $250K or high deductions. It’s important you confirm that this before exercising an ISO as exercising can trigger AMT.

1. Do you hold more than 10% of the voting stock of the company or will you be eligible to exercise $100,000 or more in options this year?

-   If you answer yes to either of these factors than your ISO will automatically be deemed an NSO unless the company takes certain measures.

It’s always a good idea to consult with a lawyer or tax advisor if you’re not sure what the tax implications will be of receiving equity. For example, many employees don’t realize that they are subject to AMT treatment and find themselves with a large tax bill after exercising an ISO grant. A quick chat with an advisor will help you make an informed decision on the best form for your equity compensation.

Vesting

It is standard for all employee stock or options, including the common stock held by founders, to be subject to vesting. What exactly is vesting? It’s a timeline or schedule on which you “earn” the right to own your stock. Your offer and the grant paperwork should set out the milestones that you must meet and the portion of stock that will “vest” upon completion of each milestone. Usually the milestones are tied to your continued employment with the company over time. For example, the most common vesting schedule in the start-up community today is vesting over 4 years with a one-year “cliff.” This means that the first 25% of your grant will vest after one year (the “cliff”) and 75% of the grant will vest monthly over the next three years. The day your grant begins vesting is called the “vesting commencement date” and is usually tied to your first day of work. So let’s say you receive an option grant for 100 shares of stock, standard vesting with a vesting commencement date of March 29, 2015. Assuming you continue to work for the company uninterrupted, here is how your grant will vest:

Date	# of Shares Vested
March 29, 2015	0
March 29, 2016	25
April 29, 2016	27
May 29, 2016	29
And so on monthly until four years later…
March 29, 2019	100

When Can you Purchase Your Stock?

Stock If you purchase stock through a direct stock sale, you must complete the purchase within 30 days of the board’s approval of the sale. When the stock is subject to vesting it is referred to as a restricted stock grant. Even though you have paid for and hold both vested and unvested shares of the stock in your name, it remains “subject to repurchase” by the company. This means that if you fail to meet a milestone, e.g. stop working for the company before your 4-year anniversary, the company has the right to buy back all or some of the unvested shares, usually at the lower of the price you paid and the current fair market value. Using the example above, if you quit on June 1, 2016, you would have vested in 29 shares of stock. The company will have to pay you to repurchase the remaining 71 shares that have not yet vested. If, however, you originally received the shares in exchange for services (meaning you did not pay cash for the shares), then the unvested shares are said to be “subject to forfeiture,” meaning you forfeit the right to the unvested shares if you fail to meet the milestone. Options Companies also specify in advance whether you can purchase the stock underlying an option grant before it has vested. If you can purchase unvested shares, the option grant is “early exercisable,” if you have to wait until the shares vest in order to purchase them, the grant is not early exercisable. Taking the vesting example above, if the grant of 100 shares is early exercisable then you can purchase all 100 shares on March 29, 2015, even though zero shares have vested. In this scenario, the purchased but unvested shares are subject to repurchase by the company, just as with a restricted stock grant. If, on the other hand, your shares are not early exercisable, then you can only purchase those shares that have vested, i.e. 25 shares on March 29, 2016, 2 additional shares the next month and so on. Every option grant will specify the window within which all vested shares must be purchased, typically 7-10 years after grant assuming you are still working for the company.

Tax Implications of Vesting

When you purchase stock that is still subject to vesting it’s extremely important that you be aware of the tax consequences associated with vesting. The IRS treats each vesting milestone as a taxable event. In other words, every time you vest in shares (i.e. at your cliff and each month after) you have to report ordinary income on the difference between your exercise price and the fair market value of the newly vested stock on that date. This is a tiresome and sometimes difficult task. However, the IRS has provided a one-time election called an 83(b) election that allows you to be taxed for all vested and unvested shares on the date of purchase. If you file this form with the IRS within the strict 30-day timeframe after purchasing your shares, you will only have to pay taxes on the stock once, rather than at each vesting date. For instance, if you purchase all 100 shares from the above example on March 29, 2015 and file an 83(b) election, your tax liability should be zero for the whole grant since your strike price on the date of grant should be equal to the fair market value. If, on the other hand, you purchase all the shares on March 29, 2016 and timely file an 83(b) election, the fair market value likely will be greater than your strike price. However, because you filed the 83(b) election, you only have to pay taxes once on the whole grant based on the spread on the day you purchased the shares, rather than each time additional shares vest. The most important thing to know is if you purchase shares of unvested stock pursuant to an NSO or a direct stock grant, then you absolutely should file an 83(b) election form within 30 days of purchase. See Equity Compensation Mechanics for more details on the process of receiving your equity.

Acceleration

What happens if the company gets purchased or if you get fired prior to all your shares vesting? The short answer is nothing, unless the company specifies otherwise. In rare cases the company’s bylaws or stock plan will include a contingency for unvested options upon an acquisition or merger, but more often than not this will be negotiated at the time of the merger. Instead, you may be able to negotiate the inclusion of “acceleration” in your original grant. Acceleration is the speeding up of vesting for a portion or all of your unvested shares upon the happening of a specified event. There are two standard types of acceleration: “Single trigger” and “Double trigger.” Single Trigger acceleration is when all or part of your unvested shares vest upon the happening of a single event – usually a “change in control” or an “involuntary termination.” Double trigger acceleration requires that both events occur, first a “change of control” followed by an “involuntary termination” within 12 months. The definitions for “change of control” and “involuntary termination” will be laid out in your option paperwork or in the company’s stock plan. In general: a “change of control” is a sale or merger of the company and an “involuntary termination” means a termination for something other than “cause,” such as a failure to perform your duties, violation of the law or company policy, breach of your contract, etc., or if you resign for “good reason,” such as a drastic reduction in your duties and pay or moving your principal workplace more than 30 miles from your home. If you’ve successfully negotiated the inclusion of acceleration in your grant, be sure that your grant paperwork properly reflects the agreement. If your grant does not include acceleration, there’s still a chance that your unvested shares could be accelerated upon a “change of control,” assuming the company’s stock plan allows this flexibility.

Conclusion

Equity compensation has the potential to provide a big payoff to an employee but it can be complicated and confusing to navigate at the outset. This breakdown of the fundamentals of equity compensation should provide you with the tools to get started with your grant. Read the rest of the related equity articles to dig a little deeper into the nuances of your equity. [1] Terminology can get confusing around equity matters. The terms stockholder and shareholder are more or less synonymous as are stock and share. For the purposes of this article, I will use them interchangeably. [2] Note that some companies are setting up a class of stock called Founders’ Preferred Stock or FF Stock. This is a completely separate class of stock, different from both Common Stock and traditional Preferred Stock that is held only by founders. It functions as a way for founders to get cash out of the company in the event they need some liquidity. FF stock can be sold to an “accredited investor” and upon sale it converts into the latest series of Preferred Stock. [3] The different rights that go along with each class of stock can be found in the company’s Certificate of Incorporation (also referred to as a charter).
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