Whether it’s attracting new employees to join your growing startup, or rewarding the employees who have stuck by your side, knowing what types of equity incentives you can provide can be a powerful way to grow and incentivize your team. There are many considerations to take into account when choosing what incentives to offer, including who you are offering them to, what you wish to gain through the offering, long-term consequences, and tax considerations. Though not an exhaustive list, here is a discussion of some equity considerations that can be offered by LLCs and C-Corporations.
Restricted Stock: Restricted stock is stock that is subject to certain restrictions until it vests, or comes to maturity. Different types of vesting can include time-based or milestone vesting, where an employee must work a specified number of years, or achieve a particular goal(s), to receive 100% of the stock. Once the stock is no longer restricted, the employee becomes the record owner of the shares of stock, and he may also hold voting, dividend, and other shareholder rights. These additional rights are spelled out in a company’s equity incentive plan and/or an equity award agreement, but can consist of as many or few additional rights as desired. The shares of stock that are restricted prior to when the stock is fully vested are subject to forfeiture (typically in the event of termination) and are non-transferrable by the owner of the stock. Many private companies retain repurchase rights on the shares an employee acquires upon vesting. This is because, most often, employers do not want former employees or other service providers to hold minority shares in the company, nor do they want the shares to be sold to third parties. This can also raise a red flag from the point of view of angel investors, venture capital funds, or other institutional investors. Also, proper management of restricted stock in a company’s cap table and other equity incentives offered to employees, independent contractors, advisors, and other service providers signal to investors that the company is taking issues of corporate governance seriously.
Restricted stock has many advantages including having a significant retentive effect, it is easy to understand, and it provides certain tax-planning opportunities different than other types of equity compensation options. Some disadvantages to restricted stock are that the recipient of the restricted stock must typically pay tax on the shares when they do not have the opportunity to sell the stock. In addition, time-vesting restricted stock awards only aggregate company growth, therefore, there may not be significant incentives outside of the executive levels. Large grants of stock also have a dilutive effect on other shareholder’s share value.
Incentive Stock Options (ISOs): An incentive stock option is a type of employee stock option where the employee must often wait until the completion of the vesting period before they can exercise their right to buy the stock. Hopefully, by the time they choose to purchase the stock (at the award price at the time of issuance), the shares will have increased in market value and the employee can resell them for a profit. If an incentive stock option is exercised, and the shares are sold, the taxes paid are typically based on the difference between the price when the shares were granted and the fair market value at the time they are exercised. That tax is also deferred until such time the stocks are sold. The tax rate will be variable, stemming from the period of time the shares were owned.
Non-Qualified Stock Options (NSOs): Non-qualified stock options are often given to non-employees, such as independent contractors, advisors, or other service providers. NSOs grant the right, within a designated timeframe, to buy a set number of shares company stock at a preset price, typically the same as the market value of the shares at the date granted. Recipients will have a deadline to exercise these options, known as the expiration date. If the date passes without the options being exercised, the award recipients forfeit their NSOs.
There is an expectation that the company’s share price will increase over time. That means award recipients stand to potentially acquire stock at a discount if the grant price is lower than later market prices. However, the recipient will pay income tax against the difference between the fair market value price of the stock when the option is exercised. Once the options are exercised, the award recipient may choose to sell the shares immediately or retain them. The difference in tax treatment between ISOs and NSOs is that the stock from an NSO is taxed twice; first upon exercise and later when the stock is sold. In addition, ISOs are taxed later, when the sock is eventually sold, where NSOs are taxed as soon as the stock option is exercised. Unlike ISOs, which can only be granted to employees of the company, NSOs may be granted to employees, directors, contractors, and consultants.
The terms of the options may require employees to wait a period of time for the options to vest, and the employee could lose the options if they leave the company before the stock options are vested. There might also be clawback provisions that allow the company to reclaim NSOs for a variety of reasons. This can include insolvency of the company or a buyout.
Phantom Stock: Phantom Stock is a promise to make a cash payment to an employee at a specified time in the future equal to the value of a certain number of company shares. Advantages to phantom stock are that they provide retentive value, because they are tied to the full fair market value of the company’s stock and are only taxed when the award is cashed in. Phantom stocks also tie the employee’s compensation to the success of the company without diluting shareholder value.
Cons to phantom stocks are that they require the company to have cash flow to be able to make a cash payment to the employee, and time-vesting awards reward only company-wide growth and may not be ideal awards for employees that are not in a position to have a direct impact on a company’s stock price.
Limited Liability Company (LLC) Incentives
Phantom Units (Synthetic Equity)- Phantom Units, the equivalent of phantom stock in a corporation, are the right to receive a cash payment at the occurrence of a predetermined event (i.e. the sale of an LLC or a substantial amount of its’ assets (a Liquidity Event), a cash distribution by the LLC to its members (a Distribution), etc.). These units are paid out at the fair market value at the time of the event and can be subject to vesting. Phantom units are the type of “Synthetic Equity” that is the most frequently used form of equity compensation provided by LLCs, primarily because they allow the recipient to receive equity without being a legal owner (or member) of the company. This, in turn, allows the recipient to benefit from any profits, distributions, or sales of the company without giving them ownership of the company or diluting existing shares. Popularity also stems from the simplicity and contractual flexibility that goes along with issuing phantom units.
The recipient, after receiving the phantom units, can continue as a W-2 employee. The recipient is also taxed only when the cash is distributed and is taxed as ordinary income. The LLC will receive tax deductions for the amount of income recognized by the recipient.
Phantom Unit Appreciation Rights (Synthetic Equity)- Phantom Unit Appreciation Rights are similar to Phantom Units. They entitle the recipient to a payment at some event (typically liquidation of the LLC), and they do not dilute the existing membership units. However, unlike Phantom Units, Phantom Unit Appreciation Rights entitle the recipient to only a payment equal to the increase in value of the LLC from the point of issuance. These rights can also be subject to a vesting period.
Profits Interest (Equity)- Profits interests are frequently used because of their favorable tax treatment and contractual flexibility. They are, however, more complicated to implement than phantom equity or phantom appreciation rights, because they require a modification to an LLC’s operating agreement if the recipient was previously a W-2 employee; they are now treated as an LLC member. Under a profits interest, the recipient is awarded a right to a portion of the LLC’s future profits. The value of the profits interest at the grant date is $0, and the recipient is only entitled the specified portion of the future profits of the company.
Restricted Units (Equity in the form of Profits Interest + “Capital Interest”)- With Restricted Units, the recipient is awarded a portion of the LLC’s current value and future profits in the form of restricted units of LLC interest. This type of incentive, however, is generally not used because it tends to be unattractive to the recipients from a tax perspective. With Restricted Units, the recipient is a legal owner, or member, of the LLC. The recipient receives payment after the sale of the LLC or a substantial amount of its assets, or at points of distribution. Voting rights, which typically are associated with members of the LLC, are optional when discussing Restricted Units. An LLC’s operating agreement and award agreement can have provisions that limit, or restrict, the rights of the unit holder.
Restricted Units can be subject to vesting, which affects the recipients from a tax perspective. The Fair Market Value of the award, less the amount paid by recipient for the award, is taxable compensation to the recipient on vesting date(s). The recipient’s tax may be accelerated if recipient makes a timely 83(b) election. The LLC receives a compensation tax deduction at the fair market value of the award. The LLC may need to make a loan to the recipient to cover the tax liability to make the receipt of the award economically feasible for the recipient.
For more articles, please visit Fridman Law Firm’s blog.
Have questions regarding Employee Equity Considerations? Schedule a free consultation with us today!