Many founders who are growing their business don’t have the cash flow to match salaries that top talent can potentially get elsewhere. Equity compensation, which pays employees with a stake in the company, is an appealing option for startups to get around this problem and bring in high-caliber talent.

At Nexus Louisiana’s first MicroBREW event, Innovation Catalyst’s Bill Ellison and Ben Brodnax shared the basics of equity compensation, when to use it and how it presents in different structures.

What Is Startup Equity Compensation?

Equity, or the right to purchase equity, offers employees, board members or advisers an alternative, noncash form of compensation. “Equity is simply ownership in a company,” Brodnax said. It can operate differently based on the structure.

Basic Terms

A grant simply refers to the act of granting someone equity or the equity granted.

Stock refers to ownership in a company. When you grant an employee stock, you’re granting them shares in the company, along with voting rights and other perks that come with ownership.

Stock options, on the other hand, are the right, but not the obligation, to buy shares in the company at the strike price (see below).

Exercising applies only to stock options and refers to when the strike price is paid and the options are purchased. Once exercised, you own actual shares in the company (versus the options you previously had).

The strike price, or exercise price, is the price at which employees can purchase shares in the company. If an employee is buying 100 shares at the strike price of $1, the employee will write the company a check for $100. Generally, the strike price must be equal to the fair-market value of the company’s common stock.

The 409A valuation is an appraisal of a private company’s stock in preparation for issuing shares to workers. If audited by the IRS and the strike price is less than the fair market value of the company’s common stock, the employee may be required to pay ordinary income on the vested options, plus a 20% understatement penalty.

Restricted stock has vesting requirements that need to be met before employees can either own the stock or have the right to exercise their options. These are typically tied to performance and retention. Many employers will set individual performance metrics that need to be met before employees can exercise their options.

Employers can also set time frames on when employees can exercise their options. These are typically designed to encourage retention. A vesting schedule with a one-year “cliff,” for example, means you have to work for the company for a year before you own the stock or have the right to exercise your stock options. Employees who are either fired or quit before reaching the cliff won’t receive any equity compensation.

Equity recipients pay taxes on the shares they exercise. Taxation related to equity compensation is very complex. Depending upon the type of equity compensation plan, the grantee may be taxed at the time of the grant, when the stock/stock options vest, when the options are exercised or when the stock is sold.

Typically, the equity compensation is taxed as ordinary income at the time of grant, vesting or when exercised. Once the grantee owns the stock, any sale of the stock will be taxed as either short-term or long-term capital gains, depending on whether the stock was held for less or more than one year.

When equity compensation is granted with vesting requirements, the recipients may have the option for an 83B election, allowing them to pay taxes on stock at the time they’re granted. The rationale behind this election is that, once those shares gain in value, the cost of taxation will also increase.

An 83B election allows you to front-load that cost when it’s lower rather than paying higher taxes down the road. The risk is that you pay taxes on the equity compensation on the front end, and the company goes out of business or the equity never has any value. If that happens, you don’t get reimbursed for the taxes paid.

Finally, dilution refers to the decrease in the ownership percentage of existing equity holders when new equity is issued. The more shares you grant, the smaller the ownership percentage of each share becomes.

Why Offer Equity Compensation?

Startups generally have little to no cash on hand to pay market value to the talent they need to grow. That’s where equity comes in: Offering ownership in the company adds to the employee’s total compensation and rewards them for the company’s success. Equity compensation can be a powerful tool for retention, especially if employees need to fulfill vesting requirements before exercising their stock.

Equity compensation also allows employees to tie their success to that of the company, incentivizing higher performance. Very young companies typically rely on equity to attract and pay the employees they need to move forward. In more mature startups with better cash flow, equity is more often used to sweeten the deal.

Types of Equity Compensation in Different Structures

Regulations for providing equity compensation differ by organizational structure. Here’s how equity compensation works in two common structures: corporations and limited liability companies (LLCs).

Corporations

In a corporation, equity holders own stock, a security that represents ownership.

Qualified stock options, or incentive stock options (ISOs), are a popular equity package because they offer unparalleled tax benefits. In this type of employee stock-purchase plan, employees are not taxed at the time of grant or when they exercise their options. Typically, employees are required to hold this type of stock for a year, at which point they’ll be subject to long-term capital gains taxes. If they sell their shares within the year, they’ll have to pay higher short-term gains taxes.

“There are certain requirements that must be met in order to grant this type of plan to your employees,” Brodnax said. One of those requirements is that it can only be granted to employees — not board members, advisors or anyone outside of the company. If any requirements aren’t met, the stock becomes nonqualified.

Nonqualified stock options are taxed as ordinary income based on the difference between grant price and the fair market value of the stock at the time they’re exercised. As the stock appreciates in value over time, you’re taxed as capital gains or loss on the difference between what you paid and what they’re worth at the time you sell them.

In practice, these stock options are subject to 409A valuations, so the option’s strike price should be at least valued at the fair market value of the company’s common stock. The 409A valuation does apply in the case of an audit, but the burden of proof falls to the auditor, not the grantee of the stock.

Restricted stock awards (RSAs) are typically used by young corporations that don’t yet have a lot of value, Ellison said. With RSAs, 409A does not apply, allowing employers to offer stock at fair market value, a discount or for free. This type of stock award typically has a set vesting period, during which grantees are classified as owners, earn voting rights and receive dividends, but they can’t sell RSAs until they vest.

Restricted stock units (RSUs) can be granted to anyone, and they are always granted without a strike price. Ownership is not granted until they’re vested. RSUs typically apply to more mature, liquid companies so that the grantee can sell some of the stock to pay the taxes when the stock vest.

Limited Liability Companies

You become a member of the LLC when you’re granted equity, and you hold a membership interest.

Capital interests entitle the holder to a slice of the LLC’s existing capital at the time of the grant. Tax implications vary based on vesting requirements, such as a vesting schedule or performance requirements, as well as whether there is an 83B election.

One of the most important tax implications is that the grantee is now taxed as a partner in the LLC rather than an employee — requiring the grantee to pay self-employment taxes (rather than the LLC performing the withholding) and carry the cost of their own Social Security and Medicare taxes.

For these reasons, it’s not common for LLCs to grant capital interests, Ellison said.

When profit interests are granted by an LLC, the recipient does not participate in the existing capital (value) of the company but only participates in any future income and appreciation in value of the LLC. Profit interests are always free to the recipient (i.e., they never have a strike price), and they typically have vesting requirements. Because the recipient only has an interest in the future value of the LLC, profit Interests have no value upon being granted.

Furthermore, as long as certain requirements are followed, profit interests are not taxed until they are sold and, if held for more than one year, will enjoy long-term capital gains tax treatment. For this reason, profit interests are the primary equity compensation issued by LLCs.

Like with capital interests, if an employee of an LLC is granted profit interests, they will be taxed as a partner in the LLC, not as an employee.

It’s important to understand that startup equity compensation is an incredibly complex topic, Ellison said, with general rules that come with many requirements and exceptions. If you’re interested in developing an equity compensation plan for your startup, consult your legal counsel to determine the right plan for your business.