Guest Blog #2: Employee Equity Need-to-Knows, by James Johnson
What You May Need to Know Before Granting Employees Equity
If you’ve decided to grant your employees or other workers or service providers—such as independent contractors, attorneys, accountants, or advisors—with equity compensation or incentives, you’ll need to make several decisions about what kind of equity you want to give, and take several steps to put a compensation/incentive plan together and ensure legal compliance.
Types of Equity Grants
Employee equity compensation grants can take one of several forms. Grants can take the form of restricted, or “vesting,” equity, as well as options to purchase stock/equity. In addition, the exact nature of the equity can depend on how your company is structured — if your company is a LLC you may grant membership units, or if your company is organized as a corporation you may grant stock, often with different rights than other classes of equity.
With restricted or vested equity, employees are restricted from transferring the stock until it “vests” after a period of time or upon the occurrence of an event (such as a product launch or revenue milestone). The employee typically holds the equity and is entitled to exercise any rights associated with the equity. However, if the employee leaves or is otherwise severed from the company before equity vests, the unvested equity is forfeited or repurchased by the company.
Restricted equity grants can sometimes be simpler to construct and simpler to tax. Normally, the employee reports the difference between the price paid for the equity and the fair market value of the equity at the time of vesting as ordinary income. However, the employee can choose to pay tax at the time of grant rather than at the time of vesting. Paying the tax at the time of grant can allow the employee to avoid a larger tax bill if the value of the equity rises between the time of grant and time of vesting, but the employee takes the risk that the equity decreases in value, or that he or she forfeits unvested equity — any paid tax is not refunded.
Options allow an employee to purchase equity at a stated price. The option to purchase is also usually subject to a vesting period or condition; once the option vests, the employee then has a set limited period of time, normally 5 to 10 years, to exercise the option. Options fall into one of two categories: incentive and non-qualified options.
Incentive options give exercising employees certain tax benefits, assuming certain qualifications are met. Tax benefits of incentive options can include no ordinary income tax on exercise; however, in practice it’s often difficult to meet the requirements for incentive options, and employees sometimes end up with unexpected tax liabilities.
Non-qualified options are all options that are not incentive options. Generally, the options are taxed to employees as ordinary income, and companies are permitted to take deductions on the exercise of non-qualified options. They are generally considered simpler than incentive options since they can be granted to all individuals who provide bona fide services to the company, as opposed to incentive options that can only be granted to employees. Employees need not worry about holding periods or tax liabilities, since estimated tax payments are usually withheld at the time of exercise.
Making Equity Grants
Companies have certain regulatory requirements they must comply with in order to implement equity compensation/incentive plans. All plans should be codified in a written document, approved by the board of directors and shareholders. If the company is granting a security, it normally will conduct the offering of the grant pursuant to exemptions in the securities laws.
The Incentive Plan
The incentive plan describes the employee equity being offered by the company, including the size of the plan and the types of equity being offered, how and by whom the plan is to be managed, eligibility, vesting terms, length of the plan, exercise price, and/or potential cash options.
Employee equity compensation/incentive plans must also comply with securities laws. Typically, companies utilize the Rule 701 exemption at the federal level; companies must also comply with securities laws in the states where the plans are offered.
Rule 701 exempts from federal securities registration equity compensation offerings pursuant to a written compensation plan. The company does not have to make a filing in order to comply with Rule 701, but it must provide offerees with a copy of the compensation/incentive plan, and, depending on the size of the plan, must also make certain disclosures, including a summary of the material terms of the plan, information about the risks of investment, and certain company financial statements.
State Securities Laws
Rule 701 does not preempt state securities registration, so companies must ensure compliance with state law. Fortunately, most states have exemptions for employee equity compensation offering, normally requiring notice filings to the state securities regulator and disclosures to the plan offerees.
If you have any additional questions, don’t hesitate to reach out or catch me around Workbar!
Disclaimer: This post is for informational purposes only, and does not constitute legal advice nor create an attorney-client relationship. Please contact an attorney for advice specific to your situation.