When you’re growing a business in its early phases, you’re usually anything but liquid. Not so very long ago, that presented a huge problem for founders. Did they burn through runway to offer competitive pay so they could lure the best employees? Or did they play it safe with payroll and hope their team could do what they needed?
Fortunately, equity grants have completely changed the game. With this tool, founders can offer top performers the compensation they deserve without needing to hand a paycheck over immediately. Easy, right?
It is an easy fix for the cash flow problem, sure, but equity grants are anything but simple. In fact, if you’re planning to offer them at your startup, you should carefully consider your options.
To help you there, let’s look at six different types of equity compensation.
#1: Restricted stock
Restricted stock gives you a way to grant your team equity without the risk that they’ll cash out right away. Under your plan, you issue a certain number of shares to an employee. They get those shares — giving them voting rights and access to dividends — right away.
The catch for the employee (the restriction, hence the name restricted stock) comes from the vesting schedule. Under the terms of the restricted stock plan, employees earn the right to exercise their shares on the laid-out vesting schedule.
Most restricted stock plans vest shares to employees over a period of 3–5 years. Usually, this vesting is tied to some other requirement. Most commonly, the employee needs to stay on as an employee for shares to continue to vest.
Once any share reaches its vest date and the employee has met the requirements for vesting, that share becomes theirs. They don’t need to purchase it to own it.
#2: Restricted stock units (RSUs)
Restricted stock units (RSUs) function similarly, but they offer a slight advantage to your company in that they minimize what an employee gets from their grant date. Unlike traditional restricted stock, which gives employees shareholder rights at the grant date, RSUs are simply a promise to issue shares at a future date (i.e., according to the plan’s vesting schedule).
This means your company isn’t responsible for paying dividends to the employee until their vest date, and you don’t have to worry about diluting your voting rights right away.
RSUs offer some upside for employees, too. Unlike stock options — which we’ll explore next — employees don’t need to buy shares to own them. Instead, ownership is granted at their vest date.
#3: Stock options
A stock option gives an employee the right to buy shares at a preset price. This offers an advantage to employees who join startups early. Stock options issued to them get tied to the company’s value at that point (i.e., its fair market value at the grant date). Ideally, then, the employee gets stock options with an exercise price — also called a strike price — well below what the share will sell for in the future.
Like restricted stock and RSUs, stock options usually vest over time, often as the employee remains employed with the company.
There are a couple of specialized types of stock options that you might want to explore:
- Incentive stock options (ISOs): These stock options can only be issued to employees (not contractors or consultants, for example). With an ISO, the employee can defer tax payments on their shares until they actually sell them provided they meet two criteria. First, they have to hold the shares for two years from the grant date. Secondly, they need to hold them for one year after exercising (i.e., buying) them.
- Non-qualified stock options (NQOs): You can issue NQOs to individuals who aren’t technically employed by but are involved in your startup, like consultants. While they don’t offer the same tax benefits as ISOs, employees and other players with NQOs can avoid the high capital gains tax rate by holding shares for at least a year after exercising them.
#4: Performance shares
If you want to tie a share’s vesting to an employee’s performance or the company’s performance in general, you can issue performance shares. This can give you a way to motivate your team to meet KPIs.
It also poses a risk, though. If those benchmarks aren’t hit and folks miss out on shares, resentment can build quickly.
To provide some kind of baseline, many performance awards apply a multiplier to the stock issued under the plan. The better the employee/company performs, the higher the multiplier— consequently, the more shares they’ll be granted.
#5: Phantom stock
Equity grants give you an excellent way to incentivize employees without creating major overhead for your startup. But they do come with the risk of ownership dilution. As you grant equity — and especially as it vests — you should absolutely keep an eye on your cap table.
Founders who want to avoid this risk sometimes issue phantom stock. This is essentially a promise to pay an employee a cash bonus equal to the value of a certain number of shares, or their increase since the grant date.
Be advised that if you do choose to issue phantom stock, you need to plan for a cash outlay. As shares vest and employees have the chance to redeem them, most will.
Additional stock benefits to consider
On top of these types of equity grants, you can also look into creating programs that offer employees financial advantages when it comes to your company’s shares. Specifically, many startups offer:
- Stock appreciation rights (SARs): This perk lets employees increase the value of any applicable shares if your company’s fair market value grows over a predetermined period. SARs let employees get the share value appreciation in cash or additional shares, per the terms of your plan, once the appreciation period ends.
- Employee stock purchase plans (ESPPs): This program lets employees use payroll deductions to buy company stock at a discounted price.
If you want help exploring equity grants — and their tax implications — at your company, we’ve got you covered. Get in touch with our team of equity compensation tax planning specialists today.