The competition for both financial capital and talent is a perpetual challenge for startups of all sizes. Compared to large multinational companies, startups are consistently strapped for cash. To provide market-competitive compensation and incentives, equity-based compensation becomes an effective tool to attract and retain talent, including employees, consultants, board members and advisors.
Understanding Equity Compensation
There are different forms of equity compensation, which include:
- Restricted Stock Agreements (RSAs) - RSAs are a type of equity compensation that grants you company stock with certain restrictions. Ownership of the shares begins on the date you accept the grant and satisfy any purchase price requirements, but typically, the shares will still be subject to vesting conditions.
- Restricted Stock Units (RSUs) - RSUs are rights to acquire shares of common stock, under which the shares will be delivered to you as you satisfy certain conditions. The vesting schedule and other requirements for an RSU grant are outlined in the RSU agreement.
- Stock Options - Stock options allow an employee to buy a specific number of shares at a pre-set price. The goal is to allow recipients to share in the startup's potential growth by acquiring shares at a favorable price.
Equity Compensation in 60 Seconds
Withum’s Founders and Tech Executive Services Team helps simplify equity compensation and explain some general tax considerations of different types of equity compensation in this short video series.
Types of Stock Options
The two types of stock options are Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). ISOs are typically reserved for employees and offer specific tax advantages, making them an attractive choice for many. NSOs can be issued to employees, contractors, advisors and board members, but they are subject to different tax treatment.
To encourage retention, stock options are typically subject to a vesting period. Each stock award has its unique vesting schedule, and a typical example is a 48-month vesting schedule with a one-year cliff, which is the earliest point where the stock options begin to vest.
As a startup grows and scales, it may provide stock compensation that ties vesting to specific performance metrics or market conditions. For instance, vesting might depend on meeting sales targets or achieving exact stock prices or earnings per share. These incentives are typically associated with late-stage startups and are subject to additional accounting and valuation considerations.
In some instances, startups may permit early exercises, allowing recipients to exercise their equity awards before the total vesting period is complete. This move comes with certain tax advantages and risks, and individuals must file an 83(b) election within 30 days of exercising their options. A startup must communicate this, as it can potentially result in tax consequences for the individual(s), and they should seek a personal tax professional for additional guidance.
Recording Stock Compensation Expenses
Stock compensation is considered a form of compensation and requires proper recognition of the company’s financial statements. To record the expense correctly, companies need to calculate the fair value of the option, allocate the expense over the vesting period, and include the compensation on the Profit and Loss (P&L) statement.
Startups are typically private companies and do not have an active market to value their stock. Valuation of the stock requires sophisticated level 3 valuations and typically uses a Black-Scholes approach. Startups should consider connecting with the accredited Withum’s Valuation Services Team for best practices.
Taxability of Stock-Based Compensation
The tax treatment of stock-based compensation varies depending on the type of equity award granted. Companies should frequently consult with a trusted tax professional for guidance related to the tax implications of equity compensation. Withum’s Tax Services Team provides accounting and tax advisory for startups of all sizes.
Conclusion
By offering equity compensation, a startup can align its interests with employees, contractors, board members, and all those involved. This decision should be strategized and executed with diligence to ensure the financial and tax complexities and treatment are understood and a startup is resourced to make informed decisions.Our Outsourced Accounting and CFO Support Services teams have the expertise and experience to support all things startup, including forecasting, income taxes, fundraising, financial reporting and CFO Advisory.
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Contact a member of Withum’s Outsourced Accounting Systems and and Services (OASyS) Team to discover how we can support your growing organization.
