Due to some recent conversations I’ve had about compensating people with equity, I thought it would be helpful to cover some basics on this form of compensation.
Sometimes newer venture CEOs like to tell employees, consultants or board members that they will be getting equity without really knowing what they have promised. This article only scratches the surface of the legal and tax issues related to equity compensation so PLEASE consult your attorney or accountant before making any promises of equity compensation.
First, it’s important to understand whether you are promising someone stock or stock options. Providing stock as compensation is giving someone immediate ownership in the company. A stock option gives the individual the “right” or option to purchase stock at a later date at a predetermined price. So what are some important characteristics of these two types of equity compensation?
The biggest mistake made in issuing stock is not realizing that the fair market value of stock compensation is taxable as wages for employees or non-employee compensation for consultants or directors. Sometimes companies issue the stock before they have made any cash payments of payroll and now they have to report and pay taxes on the stock compensation. The obvious drawback to the person receiving the stock is that they have to pay taxes without ever receiving any cash to pay those taxes.
The key thing to remember with stock options is that in most cases the “strike price” i.e., the price at which the optionee can purchase the stock in the future must be the current value of the underlying stock. The benefit to the company of issuing options is that the optionee is NOT an owner and has none of the rights of ownership until the options are exercised which normally is not until the company is sold. The benefit of options to the optionee is that there is no taxable income when they are issued.
Traditionally stock options were used as incentive compensation on top of cash compensation. Lately I have seen companies issue options as the only form of compensation. The reason being the advantages explained above. The difficulty in using this as the only compensation is in trying to determine how many options to issue since there is no real value at the time of issue.
In both cases, equity can be earned over time. For options, a vesting schedule can be required. When issuing stock, the same result can be achieved by requiring a repurchase agreement where the company can repurchase the stock that has not been earned.
Some final thoughts. Issuing stock as compensation works best when issued to very early employees or contractors while the stock value is very low. This is typically before any outside investments have been received. Stock options work better later on when the company can pay some cash compensation with the options issued to make up for the below market cash compensation.
Posted by efaservices 
