Equity Incentives

  • Vesting restrictions on shares held by the founders

    Founders should put vesting restrictions on their shares. "Vesting" means that you need to "earn" your shares before you are allowed to keep them if you leave the company. Investors will insist that the founders' shares are subject to vesting, because it is important that the team they are investing in is motivated to stay with, and build value in, the company. As founders, you should want vesting restrictions imposed on each other's shares as well. Otherwise, one founder could just leave the company and keep his or her shares while the other founders are the ones working hard to build value in the business. 

    Accelerating vesting on a sale or termination

    You may want the vesting of your shares to accelerate if you are fired or the company is sold. Is that a good idea? Will your investors agree to this?
     
    Acceleration of vesting if you are fired (terminated without cause) sounds like a good idea. Your investors won't generally see it that way, however. First of all, proving you have "cause" is not easy to do. Second, investors don't want to terminate you—you're a primary reason they made the investment in the first place—and they want and need you to build the company. In the end though, they have their money (and their own investors) they need to think about, and they will make a change if they have to. That's a difficult time for the company and they will need your unvested shares to recruit and incentivize your replacement. So, investors don't generally allow for your shares to accelerate in these circumstances.  
     
    For similar reasons, acquirers of companies don't want the talent they are acquiring to have a windfall on closing due to accelerated vesting. They may need those vesting incentives to continue or find other ways to incentivize the team, which results in a higher acquisition and compensation costs to the acquirer (and likely a corresponding reduced purchase price for your company and its investors). Moreover, the people who are likely to benefit most from accelerated vesting on a sale are the employees who joined the company closest to the time of the acquisition. Compare those employees to the founders and earliest employees who are probably fully, or close to fully, vested by the time the company is sold. So pushing for accelerated vesting on founder shares may not really help you that much (and may make it more difficult for you to recruit employees if you aren't willing to give them the same terms).
     
    Sometimes a small percentage of the vesting accelerates upon a sale (e.g., 25% of the shares). More frequently, we see full acceleration if the person's employment is terminated without cause by the acquirer after a sale of the company (if the acquirer decides to terminate your employment then they can't be so concerned about incentivizing you can they?). This is generally referred to as a "double trigger" because it requires both (1) the sale of the company and (2) a termination without cause.  
     
    Note that it is more common for acceleration upon a sale to apply for equity held by members of the board of directors and advisory boards because  it is unusual for these people to play any role in the company or acquirer following the acquisition.

    Vesting terms that make sense

    Equity is often the primary financial motivation for taking risk in a new venture. To be a proper incentive, the reward of equity should be tied to each person's contribution to the success of the venture. In an ideal world this would mean milestone-based vesting over several years. However, the reality is that few startups can predict what milestones will be most important beyond a few months in advance with any accuracy, and therefore most equity award vesting is time-based. Shares held by founders typically vest over a four- to five-year period on a monthly or quarterly basis. Most non-founder employees vest over a four- to five-year period with a one year cliff (25% vests after the first year) and monthly or quarterly vesting thereafter for the remaining three or four years. The cliff period gives the company time to determine whether the employee is working out before the person gets to keep any of his or her shares. Sometimes founders' shares do not have a cliff.   
     
    Vesting for board members and advisors is somewhat less standardized but, in general, you should match grant size and contribution to the time period the person is expected to provide services to the company and generally provide for monthly vesting. Consistency in grant size and vesting scheme for similarly-situated contributors can save real headaches in the future, because it limits case-by-case negotiations and avoids negative feelings when compensation comparisons inevitably occur.

    Tax implications related to shares that vest

    If your shares are subject to vesting, how and when you are taxed on those "restricted shares" is governed by Section 83 of the Internal Revenue Code. Specifically, the tax consequences depend upon whether you make an election—known as a "Section 83(b) election"—under Section 83 or not.  
     
    No 83(b) election. If you don't make a timely Section 83(b) election, then your purchase of the restricted shares is not a taxable event. So there is no tax resulting from your purchase of the shares. However, when the shares vest the difference between the fair market value of the shares that vest on the vesting date minus the amount you paid for the shares is treated as income to you (even though you aren't receiving any cash from that increase in value)—and you need to pay tax (at ordinary income rates) on that income. So there's another taxable event every time the shares vest (whether annually, quarterly, monthly or otherwise). Unfortunately this means that the better the company does and the more the stock increases in value, the bigger the tax burden. Note also that the capital gains holding period for the shares would not start until the day after the shares vest. When you ultimately sell the shares, the difference between the sale price and the fair market value on the vesting date would be capital gain or loss. 
     
    A timely 83(b) election. By making a Section 83(b) election within 30 days of the date the restricted shares are transferred to you, you elect to make the purchase of the restricted shares a taxable event, because you are required to pay tax (at ordinary income rates) on the difference between the fair market value of the shares on the date of purchase and the amount that you pay for the shares. Why would you do that? Why would you elect to pay tax on an earlier date than you would otherwise need to if you didn't file the 83(b) election? Answer: Because in most cases for a startup company you will have paid fair market value for the shares (which, at incorporation, is usually nominal). So the taxable income (i.e., the difference between the fair market value and the purchase price) would be zero!  And if you filed the 83(b) election, vesting becomes a non-event for tax purposes—there is no income (and therefore no tax) on vesting!  Note that your capital gains holding period also starts earlier than if you didn't file an 83(b) election.
      
    Here's an example of the difference: Let's assume you pay $0.01 per share for 100,000 restricted shares, and the fair market value per share on the date of purchase is also $0.01. Assume the shares vest annually over four years, and on the first anniversary the fair market value of each share is $2.00.  
     
    If you timely file a Section 83(b) election, you elect to be taxed on the difference between the fair market value on the date of purchase ($0.01 per share) minus your purchase price (also $0.01 per share). So the tax on the date of purchase is zero. Vesting is not a taxable event and so you owe no tax on vesting. You only have to pay tax on the gain when you sell the shares.  
     
    In contrast, if you do not file a Section 83(b) election, you effectively defer being taxed until vesting. So while there is no tax due on the date of purchase, you do have taxable income when the shares vest. So on the first anniversary when 25,000 shares vest, you have $49,750 in taxable income (25,000 shares x [$2.00 per share ˗ $0.01 per share]). That's a big tax bill when you aren't likely to even be able to sell your shares to cover the tax.  
    Whether or not you decide to file a Section 83(b) election will ultimately depend on your particular facts and circumstances and you may want to consult with your own accountants or tax advisors before making the election. 

    Difference between options and restricted stock

    "Restricted Stock" is a term often used to refer to shares of stock of a company that are subject to vesting requirements. The shares are purchased and owned by the shareholder. The shareholder can vote the shares. If a dividend is paid on the shares, the shareholder is entitled to be paid the dividend. However, the shares are subject to vesting. However, if the shareholder ceases providing services to the company—as an employee, consultant, advisor or otherwise—the company has the right to get back any of the shares that were not then vested (typically be paying the shareholder back the original purchase price paid for the shares). With time-based vesting, this means that the percentage of the shares that the company has the right to purchase decreases over time. This is sometimes referred to as "reverse vesting" in order to describe the contrast with vesting of options where the number of shares the option holder is entitled to purchase increases over time/as they vest.  
     
    A stock option is a contract between the company and an employee, consultant, advisor or other service provider. It gives the individual the right to buy a certain number of shares of stock at a fixed price, called the exercise price. The right to exercise the option will vest—typically over time. So initially, the holder cannot exercise any of the shares, but the number of shares that become exercisable will increase over time as long as the individual continues to provide services to the company.
     
    The exercise price of an option is typically set at the fair market value as of the time of grant (when the board of directors authorizes the grant of the option). This price is fixed—so even though the value of the stock may increase, the option holder gets to buy the shares at the earlier and lower fixed price. This is the key advantage of an option—the individual gets to wait and see how the company does before paying anything out-of-pocket. If the company does well and the stock increases in value, the holder can exercise the option by paying the exercise price knowing that the shares are then more valuable than the purchase price. If the company doesn't do well and the stock decreases in value, the individual can just choose not to exercise the option and therefore pay nothing. Compare this to restricted stock, where the individual must pay for the shares (or pay tax) up-front. Unlike a holder of restricted stock, however, the holder of an option is not a shareholder until the option is exercised. Until that time, therefore, the holder cannot vote the shares, and is not entitled to any dividends paid on the shares. 

    Tax differences between ISOs and NSOs

    In the US, there are two types of compensatory stock options: incentive stock options (often called ISOs) and non-qualified stock options (often called NSOs). Companies can grant ISOs or NSOs to their employees. However, they cannot grant ISOs to non-employees. Therefore, options granted to contractors/consultants, advisors and non-employee directors - can only be NSOs. Other requirements of ISOs include: Read More...

    Granting options vs. issuing restricted stock

    Restricted stock is almost always issued to founders when the company is formed. Most early stage companies prefer to limit the number of shareholders who have the right to vote and therefore tend to instead grant options to non-founders. Also, because recipients of restricted stock must pay the fair market value of the stock up-front (as opposed to options where they wait to pay for the shares until they exercise the option) it becomes more and more expensive to purchase restricted stock as the company increases in value. As a result, most private companies will instead grant options to non-founder employees, consultants, advisors and directors. 

    Advisory board setup and compensation

    Advisory boards can be useful things—especially in the earliest phases of your startup. They are often luminaries, academics and industry experts, and having people like that who are willing to make themselves available to answer questions, provide you with insights, perspective and feedback or to merely lend some credibility to your venture can be very valuable. Calling it a "board" is a bit of a misnomer, because advisory boards rarely actually meet as a group. The amount of time they contribute is often quite limited, and they aren't generally tasked with a specific project or deliverable like a consultant would be.  Read More...

    Reserving shares under the company's option plan

    The option "pool" represents the number of shares the company sets aside in reserve under its option plan to compensate its employees, consultants, advisors and directors. The size of the option pool depends on the company's stage, circumstances and hiring needs. When the company issues shares under the plan, it dilutes the ownership percentage of the other shareholders proportionately. However, any shares reserved under the plan that are not used (i.e., that are not sold or issued by the company) do not dilute the actual ownership of the other shareholders. Therefore, the size of the option pool at the initial formation of the company doesn't really matter all that much—if the pool is too small and you need more shares, it can always be increased; if the pool is larger than you actually need, any excess shares don't have any negative impact on the actual ownership of the company. Most startups will initially reserve an option pool that is big enough to provide for the equity incentives needed to cover their anticipated hiring needs for the first six months to a year. Read More...

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