What every Startup should know about
Paying with Equity
LINDA KNOBBE, TAX PARTNER
October 17, 2016
BDO USA, LLP, a Delaware limited liability partnership, is the U.S.
member of BDO International Limited, a UK company limited by
guarantee, and forms part of the international BDO network of
independent member firms. BDO is the brand name for the BDO
network and for each of the BDO Member Firms.
PAYING WITH EQUITY
Pros
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Doesn’t use up company cash to pay
salaries
Can encourage loyalty
Gives recipients a potential share in
future success
Cons
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Can be costly to set up and manage
Reduces founders’ share of equity
Complex to value
By Mukund Mohan
bestengagingcommunities.com/2012/07/29/should-i-paymy-lawyer-or-advisor-in-stock/
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EXAMPLES OF EQUITY COMPENSATION SUCCESS
Jeremy Stoppelman
Yelp
• Cash Compensation:
$340,657
• Yelp holdings worth
$250.6 million
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Joe Mansueto
Morningstar
• Cash
Compensation:
$105,295
• Morningstar
holdings worth
$1.9 billion
Kosta Kartsotis
Fossil Group
• Cash
Compensation:
$0
• Fossil holdings
worth $716
million
RESTRICTED STOCK
Grant of company stock that may be subject to
forfeiture if certain future conditions are not met
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Equity ownership granted without a purchase price
paid by employee.
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The simplest way to grant equity ownership in
exchange for services
No income or tax until vested. Taxable as
ordinary income upon completion of vesting
schedule. Then capital gain tax applies upon sale
of stock.
May qualify for 83b election and allow recipient
to "prepay" taxes based on stock value at grant
date. This election reduces overall taxes if stock
appreciates between grant date and vested
date.
Tax deduction for company when restrictions
met, or at date of 83b election.
Immediate ownership, but subject to later
forfeiture (typically time or performance-based)
Complex issues regarding determination of grant
date, vesting date and valuation
Compensation value is Intrinsic value (difference
between FMV and strike price).
PHANTOM STOCK OR STOCK APPRECIATION RIGHTS
Contractual bonus tied to company stock
value or appreciation of its value
Can be settled in cash or stock
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Taxable as ordinary income on amount of
bonus
Tax deduction upon bonus paid
Does not give away company equity,
unless settled in stock
Possible ERISA (Employee Retirement
Income Security Act) issues if it resembles
a qualified plan (ESOPs or 401(k)). If the
plan is designed for a limited number of
employees, or as a bonus for a broader
group of employees that pays out annually
based on a measure of equity, would most
likely avoid these problems.
Valuation can be complex.
INCENTIVE STOCK OPTION (ISO)
Option to purchase company stock
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Preferential tax treatment
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Limits on use, must be designed within ISO
rules to qualify
Pays only if stock price increases
Taxable at Capital Gains rate when stock
is sold. Ordinary taxable income if stock
not held for 1 year after exercise and for
at least 2 years after the grant of the
option
Possible AMT consequences
No tax deduction unless employee
disposes of stock prior to meeting holding
requirements
Ownership is effective when option
exercised.
Limits on Exercise Price, Value of Grant,
Term of Grant and Term of Plan
Complex plan documentation
Complex valuation and amortization
ISO Qualifications
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Must be granted to an employee (not advisors, contractors, etc.)
Exercise price must be must be at least equal to grant date Fair Market Value
Cannot be transferred-except on death
Must be granted pursuant to a plan approved by board of directors
Must be granted within 10 years of plan approval
Must be exercised within 10 years of grant and within 3 months of a termination from
service
7. Aggregate Fair Market Value of all ISOs exercisable during any calendar year may not
exceed $100,000.
If these are not met, the option is treated as an NQSO
Note: additional rules if granted to a 10% or greater shareholder.
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NONQUALIFIED STOCK OPTION (NQSO)
Option to purchase company stock
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Corporate tax deduction when exercised
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Taxable as ordinary income on exercise
(for spread between strike and FMV of
shares); Then, capital gain tax on growth
after the exercise.
Tax deduction upon exercise when option
exercised
Possible 409A considerations, if exercise
price is less than FMV
Complex plan documentation
Complex valuation and amortization for
GAAP purposes
PARTNERSHIP PROFITS INTEREST
Holders of Profits Interest granted share of
increase in value of company over stated
period of time Shares in profits only, not an
equity stake.
Can only be utilized for LLCs or partnerships
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May need valuation to determine company
value
Taxable at Capital Gains rate when
disposed (exit or sale)
No taxation at grant if "safe harbor" met
Allocated profits from partnership are
taxable when reported on Schedule K-1.
No tax deduction
Immediate ownership, but only to the
extent of increased value after grant
Annual capital account maintenance
required. Multiple valuation dates creates
additional complexity.
Maintenance of capital table and
accumulated earnings/profits
Grant to an employee makes them a
partner.
409A Implications for Startups
409A Qualified Arrangements
The Internal Revenue Service created
Section 409A to address deferred
compensation. It applies, generally,
anytime compensation is earned in one
year, but not paid until a later year.
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If the 409A rules are not met, then the
compensation is taxed when earned,
not when paid.
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A legally binding obligation that the company
owes the employee (via contract or other legal
right)
Plan must be in writing
The deferral election must be made in advance
of the year in which the compensation is earned
The time and form of payment must be
determined up front and cannot change (so the
company needs to set the dates these deferred
payments will occur, it can’t just be “when cash
is available”)
Accelerated payments cannot be made (only
upon death, disability, or separation from
service)
FINAL THOUGHTS
• Pay careful attention to your cap
table and keep it updated at all
times.
• Monitor fully diluted ownership.
• Check in with your tax advisor
frequently to stay on top of tax
consequences.
• Check in with your legal advisor
to make sure you don’t grant
what you haven’t authorized.
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THANK YOU!
QUESTIONS?
LINDA KNOBBE, CPA
Tax Partner
Member of BDO’s Technology & Life Sciences Practice
[email protected]
Direct: 314-889-1136
www.bdo.com
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