Equity Compensation - Stock Options vs Restricted Stock

Incentivizing employees, advisors, and contractors with equity is important because it aligns their interests with the company's success. By giving your personnel a stake in the business, they become motivated to contribute to its growth and profitability. Equity compensation can attract and retain top talent, foster loyalty, and encourage long-term commitment. It also provides employees with the opportunity to benefit financially from the company's success, creating a sense of ownership and investment in their work.

There are 2 main forms of equity compensation most startups consider: stock options and restricted stock. We’ll go over the differences, benefits, and considerations of each. By the end of this article, you’ll have a better understanding of the options available. And it is worth noting that prior to issuing stock to personnel outside of the founding team, it is important to first establish an Equity Incentive Plan (this article provides a solid overview of what goes into these plans).

Stock Options

Stock options provide the opportunity to buy the company’s stocks at a later time. When an employee receives a document known as a stock option agreement, it grants them the right to purchase stock in the future after it vests, typically over a four-year vesting period, often with a one-year cliff. This means that as an employee works for the company, the stock options gradually become available for purchase over a period of time. The purchase price is set at the fair market value determined at the time the option was granted.

Stock options offer employees the advantage of not needing to pay an initial investment at the outset. Instead, they can decide later whether to purchase shares in the company. This approach is typically the industry norm for equity compensation once companies have secured funding and established a meaningful valuation.

For stock options, typically, employees have the right to exercise them for up to three months (the expiration date) after their employment with the company ends. However, there are cases where this period may be longer, and there are also circumstances where a company may want to grant stock options that can be exercised early.

Restricted Stock

Restricted stock involves purchasing the stock upfront at its fair market value. In this context, vesting refers to the right to retain ownership of the stock over time even after the employee (or advisor/contractor) leaves the company.

With restricted stock, upfront payment is required, involving actual out-of-pocket expenses. It involves an initial payment, and if the employee doesn’t pay the "fair market value" for that stock, then they will have to pay taxes on the spread between the fair market value and the amount paid (and for employees, the company would also have a corresponding withholding obligation on such amount).

Restricted stock is typically utilized for founders who receive their stock early in the company's life, often before a substantial valuation is established. It can also be granted to early advisors or employees when the upfront cost to acquire the stock is minimal.

If employment with the company ends and the employee has unvested restricted stock, the company has the option to buy back the stock at its original cost. 

Administrative Considerations 

Setting up a process for stock options initially requires some effort (though it is a pretty standardized process at this point), but ongoing management is straightforward, with minimal paperwork and simplified processes upon separation from the company. Platforms like Carta facilitate efficient management of option grants. 

By contrast, restricted stock issuance involves more administrative complexity since the company must track whether recipients of restricted stock grants have filed their (all important) 83(b) elections. In addition, when the employee’s tenure with the company ends, the company must affirmatively take steps to repurchase the stock from the employee.

Voting Rights

Holders of stock options do not possess voting rights until they exercise their options and acquire the stock. Until then, they are not considered shareholders with voting rights. On the other hand, recipients of restricted stock are granted full voting rights as shareholders from the moment they receive the stock (for both their unvested and their vested stock).

Tax Implications of Stock Options and Restricted Stock

Holding Periods

When individuals purchase stock in a company and hold it for at least a year before selling, the stockholder benefits from long-term capital gains tax rates instead of the higher short-term capital gains or ordinary income rates, which are often the same in most states. However, with stock options, this holding period doesn't begin until the individual exercises their options. This tax advantage is advantageous for employees who acquire stock earlier, assuming the company performs well and there's an opportunity to sell the stock at a profit through an acquisition, IPO, or secondary sale. Nonetheless, investing in startups is risky, as many fail and there is always the risk that the stockholder may not see returns at all.

In addition, many startups qualify as Qualified Small Businesses (QSBs) as defined by the Internal Revenue Code. If a person holds stock in a QSB (i.e. they hold Qualified Small Business Stock or QSBS) for five years (provided other requirements are met) then the stockholder could benefit from a very significant tax benefit at the federal level: the greater of the first $10 million or ten times the stock price can be tax-free upon sale. This exemption can be substantial, although state taxes may still apply depending on the state. As in the case of long-term vs short-term capital gains described above, the 5-year QSBS holding period only begins when the individual becomes a stockholder in the company. So this holding period does not start for optionees until they exercise their stock options.

Restricted stock is often favored for its potential longer-term tax benefits. When the company's valuation is low, the cost of acquiring stock is lower, reducing risk for the service provider.

In both cases—options and restricted stock—the stock price must be set at fair market value. 

Fair Market Value

Determining fair market value for early-stage private companies can be complex (and vague in some cases), but IRS rules stipulate that issuing restricted stock below fair market value results in taxable income to the employee, equivalent to receiving a taxable bonus without cash. 

Similarly, issuing options below fair market value can lead to significant tax penalties for the employee. 

To mitigate these risks, the best practice is for the company to opt to engage a third-party valuation firm to establish fair market value (often referred to as a 409A Valuation), providing a safe harbor from IRS penalties related to option pricing.

This approach ensures compliance and reduces the risk of IRS challenges, safeguarding both employees and the company from potential tax liabilities down the road.

Tax Treatment Upon Payment

One other important tax aspect of deciding between restricted stock and stock options is the way that the two are taxed at the time that payment is made for the stock. 

With restricted stock, as long as the recipient files an 83(b) Election and pays the fair market value for the stock, then there is no tax on the stock until the recipient ultimately sells the stock (e.g. in an acquisition, IPO, or secondary sale). If no 83(b) Election is filed, then every time stock vests, the recipient is taxed on the value of the shares that have vested (minus the amount paid for such shares). 

By contrast, when a stock option is exercised, depending on the type of stock option (and, in some cases, depending on the recipient’s individual circumstances), the spread between the exercise price (set when the option is granted) and the fair market value when the option is exercised may be taxable. Specifically, when the option is an NSO (typically for non-employees such as advisors and contractors), then the spread is taxable to the recipient. When the option is an ISO (typically for employees), then the spread results in an adjustment to the Alternative Minimum Tax if the employee is subject to AMT.

SPZ Legal counsels hundreds of startups and their founders on how to design and implement effective equity compensation strategies that align with their growth objectives. Please feel free to reach out to learn more about how we can support you and your team!