From startups to major corporations, equity awards can be a great way to attract and maintain a talented workforce. There are a variety of ways a company can transfer partial ownership to its employees—but not every way is equal.
In fact, some equity transfers can actually end up being very costly for employees, if not handled correctly.
Restricted Stock Purchases: How Founders Should Get Their Shares
When a startup first organizes or incorporates, it likely has little to no assets, no active business or clients, and no investments. At that stage, key personnel can be allowed to buy shares (or ownership units, for an LLC) at a fraction of a penny. Since the company is basically worth the paper the incorporation documents are written on, a fraction of a penny for a share is fair market value.
Sure, your company may have prospective value—heck, if it wasn’t likely to provide a revenue stream down the road, you wouldn’t be doing it. But that prospective value is just that—prospective. You’re taking a gamble that your ideas, your personnel, and your business model have market value. Until your company proves that, your stock has minimal value.
And that’s a good thing. Because you can sell your stock for a fraction of a penny to your initial wave of personnel. They get partial ownership and a potentially lucrative pay-off down the road; you get personnel invested in the company and its success.
Since the person is buying the shares, that person doesn’t need to pay income tax on the shares. The government will most likely take its cut down the road in capital gains tax when a person sells the shares—based on the difference in value of the share when sold and when it was originally purchased.
Of course, the company needs to be cautious how it allocates shares to its early personnel. If the company doesn’t take the necessary steps to maintain control of those issued shares, someone could walk away with a big chunk of the company without paying her dues. By issuing restricted stock, you can set up a vesting schedule—if a founder leaves the company early, the company can buy back some or all of the stock that person purchased at that fraction of a penny. That locks in the person’s incentive to stay with the company and make sure it’s a success.
There are several pitfalls for those unfamiliar with this process, though. If you’re planning on issuing shares to initial personnel and you don’t know what an 83(b) form is or does, speak to an attorney or an accountant. In a nutshell, a person purchasing restricted stock needs to tell the IRS that it bought a certain number of shares for a specific amount. Otherwise…
Restricted Stock: Not All Good Things Can Last Forever
A year has passed since you started your company and shares are now worth $1/share. You want to take your company to the next level by recruiting some very talented individuals to increase your company’s exposure, marketing portfolio, and technical talent.
You decide to issue the new marketing guru 50,000 shares to entice her to come aboard. Unfortunately for you and the marketing guru, the restricted stock ship has sailed. If you want to do a stock sale (as above), that means you need to sell her those shares at fair market value. So she owes the company $50,000 on her first day of work.
Sure, you could just give her the shares, but stock is a form of compensation and therefore qualifies as income. She’ll be paying income tax on the $50,000 she received in shares. You’ve probably just put her on the hook to pay the IRS $15,000-20,000.
And the company must pay its percentage of employment taxes on that $50,000 as well.
And there’s potentially more bad news. Imagine your employee receives $50,000 worth of shares (at $1/share) in January. By December, the company runs into some lean times and the shares are only worth $.10/share.
Guess who doesn’t care? The IRS. That employee will be taxed on the value of the shares when she received them (at $1/share), not when she files her taxes (at $.10/share). Like many people learned the hard way when the tech bubble burst, you can end up owing more in taxes on the value when the shares were issued than your shares are actually worth when you pay taxes.
For those who think the workaround is simply undervaluing the company, think again. Let’s say you decide to say the shares are worth $.10/share, knowing they’re worth more. That means your new employee just needs to pay the company (or pay income tax on) $5,000. But if the IRS audits her or your company, you’re going to have to prove your company was worth $.10/share when you issued the shares. When you fail, the IRS will be looking to collect the full amount of its taxes and fines.
And remember that 83(b) form? If an initial owner doesn’t file within the IRS deadline, he or she will be looking at tax treatment similar to the above—that is, paying income tax on nearly the entire value of the shares as they vest. When you’re looking at tens of thousands of shares vesting repeatedly over years, that can accrue a lot of tax debt.
Assuming your new employee doesn’t want to pay the company $50,000 or the IRS a healthy fraction of that, you need a better way.
For the reasons above, very few companies issue restricted stock to new hires after they raise capital or achieve significant revenue. After the company is more mature or has a higher valuation, it’s too expensive to serve as a real incentive to new hires.
So what are your options?
Stock Options: How to Distribute Equity to Later Hires
Options. Unlike selling or issuing stock, an option plan provides employees the option to purchase shares at a specific price (the fair market value at the time the option is issued). That means the employee does not actually receive any shares unless the employee decides to buy the share. Ideally, down the road, the employee will be able to purchase a share worth $2 in 2020 at the 2017 price of $0.10.
But if it doesn’t turn out that way, the employee is protected. If the 2020 shares are only worth $.01/share (or the value appears volatile), the employee will simply not buy the share. When an option vests (meaning that the employee can exercise that option by paying the corporation the option price for the share—and then receive the share), the employee is not obligated to buy the share at that time. Thus, the employee can wait until the stock value is higher or even never purchase the underlying shares. The employee controls her or his own destiny—and tax obligation—by deciding when, if ever, she or he will buy the share.
When your business has ongoing value, an employee stock option plan is likely where you’ll want to go.
Can’t the Employee Immediately Sell Some Shares to Make Money to Cover Taxes?
Probably not. Unless the company’s stock is traded on Wall Street, there is likely no clear, accessible market to sell shares in a small, private corporation. And what’s more—selling shares shortly after one receives them can result in very unfavorable tax treatment.
Can’t Founders Just Sell Some of Their Shares to New Hires?
Sometimes yes. Sometimes no. But it’s almost always a bad idea. The securities laws governing shares in privately held companies are incredibly strict and underappreciated. You can’t just sell shares back and forth among founders and new hires. Doing that can get you in trouble with the SEC and turn off prospective investors and acquirers. And again, it can also result in very unfavorable tax treatment.
Situations vary, and some have arisen where investors will buy a small portion of a founder’s shares to get the founder some actual money, when the value of his or her ownership is otherwise just on paper (in shares that are not publicly traded yet). But again, one needs to tread carefully with such purchases to assure it won’t cause problems with the SEC.
Ultimately, what fits your business depends upon what stage your business is in, who you’re issuing shares to, and how you want those shares to be issued. How various methods will be taxed will also depend upon various factors of the companies’ and the individuals’ finances, including how long the individual will retain his or her ownership.
Additionally, other mechanisms might be better suited for your company—including reverse vesting, unrestricted stock sales, capital raises, and promissory notes—depending on the situation of the person or entity receiving ownership. It is essential that you tailor the solution to your business—and assure that you haven’t set your business, and your employees, up for an unwelcome surprise the following tax season.