Most startups reward early hires for taking a risk and joining the team by giving them a chunk of equity. With all the news on major fundings and exits constantly buzzing around the startup ecosystem, it’s easy to get caught up in the hype. But, the reality is that startups are extremely difficult, and they come with a plethora of mundane, difficult, and expensive issues that you must be aware of and handle properly in order to succeed.
One such area that is rich with troublesome legal and tax issues is the issuance of equity to employees. So, below is a basic guide to help you learn about how to issue equity to employees in a startup.
How you should issue equity to early employees will depend on the unique circumstances of the particular company. It’s always best to consult a tax attorney and/or a CPA in order to make sure you are structuring everything with the best interests of the company and the employees in mind.
Below are some basic guidelines to think about when deciding how to issue equity to employees in a startup.
What are the company’s goals?
Is the company poised for fast growth and a huge exit or IPO? Or is it likely to remain privately held and grow more organically over time? This consideration can play a key role in the determination of how to issue equity to employees.
There are different options for equity compensation available depending whether your company is a limited liability company vs. a C corporation or S corporation. Equity compensation is more common in corporations, but there are ways of achieving it with an LLC as well.
The liquidity of shares is closely related to company goals. If the company is on track for acquisition or IPO, generally it will need to raise outside capital, and most of the time it will be structured as a C corporation where shares are relatively liquid. For companies more likely to be bootstrapped and grow organically, LLCs are probably more common, in which case there is less liquidity.
In corporations, equity is normally provided by either stock options or restricted stock. In both cases, the stock is usually restricted from being transferred or sold in certain ways. Liquidity is achieved when the company is acquired or goes public, and the employees then sell their shares and cash in.
As an LLC, there is no “stock” so you cannot issue shares in the company in the same way that you can in a corporation. Therefore, other arrangements must be made. Most commonly, LLC owners will reward employees through some form of sharing in the company’s profits.
Because equity compensation is more common in corporations, the rest of the article deals primarily with the details of issuing stock to employees. Here is more info on how LLCs can achieve equity based compensation through profit sharing.
How early is it?
Did you just start this company last week? Or have you been at it for quite a while? How established the company is will have an impact on what type of stock compensation to issue employees.
It is generally easiest and cheapest to issue restricted stock, making it a more attractive option for very early stage companies. Also, when you are still building out the initial founding team, restricted stock can be a better motivational tool than stock options. With restricted stock, you become an actual owner of the company when the stock vests, unlike options which do not entitle the holder ownership in the company until the option is exercised sometime in the future.
For startups that have incorporated but are still putting together the initial team, restricted stock is likely a good option. If your company already has revenue or has raised significant money, you may want to consider stock options instead.
How much is the company worth?
As a company becomes more valuable, it may be less desirable to use restricted stock. For one, there are likely to be some immediate tax consequences for the employee. Employees receiving restricted stock will have income equal to the difference in fair market value of the shares and the amount paid for the shares (which is typically next to nothing).
Alternatively, the employee can pay the full fair market value for the shares and avoid immediate tax consequences, but this is unlikely in most cases. If the company has raised substantial capital and is valuable, the share price will probably be fairly high and the employee will be unable to afford the purchase price of the shares.
Therefore, for a high-value company flush with VC capital, setting up an option pool is the most common way to go. Companies in these situations should have no trouble paying the legal fees. Typically, the company will set aside 15-20% of all outstanding shares in order to issue them to future employees as part of a stock option plan.
As a startup founder, rewarding your first hires with equity is a great way to motivate them. But it’s important to consider all the pros and cons of the different approaches when deciding how to issue equity to employees. What options are available in your situation for issuing equity to employees will depend on a few key factors:
- What the company’s goals are
- Whether it’s an LLC or a corporation
- How established the company is when equity is being issued
- How much money has been raised to date
- What the current valuation of the company is and the share price
Also, keep in mind that there are likely to be significant tax considerations with any route you take, both for the employee and for the employer. You should absolutely consult with a tax lawyer and accountant before ever attempting to issue equity to an employee yourself. If you fail to set things up properly, both the company and the employee could face harsh tax consequences and/or penalties for back-taxes down the road.