Founders Series: Stock-Based Compensation – Part I

Our most recent round of “Founders Series” posts focused on anti-SPAM legislation .

Adding to this discussion about important matters for startup founders to think about, we now turn our attention to issues relating to Hiring and Compensation – including posts focusing on and explaining stock-based compensation; equity incentives; 83(b) memoranda; and specifics regarding employees and consultants.

Stock-based Compensation in general

Start-up companies frequently use stock-based compensation to incentivize their executives and employees. Stock-based compensation provides executives and employees the opportunity to share in the growth of the company and, if structured properly, can align their interests with the interests of the company’s shareholders and investors, without burning the company’s cash on hand.

The use of stock-based compensation, however, must take into account myriad laws and requirements, including: securities law considerations (such as registration issues); tax considerations (tax treatment and deductibility); accounting considerations (expense charges, dilution, etc.); corporate law considerations (fiduciary duty, conflict-of-interest); and investor relations (dilution, excessive compensation, option repricing).

 The types of stock-based compensation most frequently used by private companies include restricted stock and stock options (both incentive and non-qualified).

Other common forms of stock-based compensation a company may consider include stock appreciation rights, restricted stock units and profits interests (for partnerships and LLCs taxed as partnerships only). Each form of stock-based compensation has its own unique advantages and disadvantages.

We’ll take a look at each of these types of stock-based compensation, starting with restricted stock options in this post and following up in subsequent posts examining stock options and then finally looking at other stock-based compensation considerations.

Restricted Stock

Restricted stock is stock sold (or granted) that is subject to vesting and is forfeited if the vesting is not satisfied. Restricted stock may be granted to employees, directors or consultants. Except for payment of par value (a requirement of most state corporate laws), the company may grant the stock outright or require a purchase price at or less than fair market value.

In order for the risk of forfeiture imposed on the stock to lapse, the recipient is required to fulfill vesting conditions that may be based on continuing employment over a period of years and/or achievement of pre-established performance goals. During the vesting period, the stock is considered outstanding, and the recipient can receive dividends and exercise voting rights.

A recipient of restricted stock is taxed at ordinary income tax rates, subject to tax withholding, on the value of the stock (less any amounts paid for the stock) at the time of vesting.

Alternatively, the recipient may make a tax code section 83(b) election with the IRS within 30 days of grant to include the entire value of the restricted stock (less any purchase price paid) at the time of grant and immediately begin the capital gains holding period. This 83(b) election can be a useful tool for start-up company executives, because the stock will generally have a lower valuation at the time of initial grant than on future vesting dates. [Note: we will delve deeper into 83(b) election considerations in a future post]

Upon a sale of the stock, the recipient receives capital gain or loss treatment. Any dividends paid while the stock is unvested are taxed as compensation income subject to withholding. Dividends paid with respect to vested stock are taxed as dividends, and no tax withholding is required. The company generally has a compensation deduction equal to the amount of ordinary income recognized by the recipient.

Restricted stock can deliver more up-front value and downside protection to the recipient than stock options and is considered less dilutive to stockholders at the time of a change in control. However, restricted stock may result in out-of-pocket tax liability to the recipient prior to the sale or other realization event with respect to the stock.

Keep an eye out for our upcoming post looking at stock options!

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