So, you’ve decided to act on your million dollar idea and formed a company. You’ve got an exciting product, momentum, and your workload is at the point where you need to bring in additional employees to help carry out your vision. What’s that you say? Not enough cashflow to pay employees a competitive salary?
Fear not, savvy entrepreneur! You might consider an equity incentive package.
Equity incentives help cash-strapped startups attract talent without digging deeply into the company’s coffers. Typically, a company reserve 5-20% of its equity as an additional perk to employee compensation. You have a few choices when it comes to equity incentives, a popular form being stock options.
A stock option is an agreement to sell a specified number of shares at a specified future date. Stock options are broken down into two sub-groups: qualified and non-qualified stock options.
Qualified vs. Non-Qualified Options
Qualified options meet certain requirements under section 422 of the federal tax Code, which provide some tax benefits to the employee upon exercising the option.
- If the employee sells the stock, it will count as capital gains, not personal income, and is taxed at a lower rate
- Employers get more simplified bookkeeping — when the option is exercised, employers do not have to withhold federal income tax, Social Security tax, or Medicare payments.
- First, you don’t have to worry about meeting tax requirements for qualified options;
- Second, most employees want the cash from selling stock sooner rather than later (one requirement for qualified options is that the employee hold the stock for either two years after the grant, OR one year after exercising the option, whichever time period is longer)–NQOs avoid this holding requirement.
The takeaway is that non-qualified options may be the better choice in most cases: only a small percentage of employees will realize the tax advantages of qualified stock options, and the costs in tracking required compliance outweigh the minimal benefits gained.
Restricted stock differs from options in that the employee pays nothing for the stock, but the stock is subject to forfeiture if the recipient terminates employment within a specified period of time. Restricted stock is taxed on the vesting date for the stock award, as opposed to options, which are not taxed until the employee chooses to exercise the option.
Stock Appreciation Rights (SARs)
Another less popular equity incentive plan are SARs. In SARs, a contract entitles an employee to receive the appreciation in a specified number of shares of stock over a specified period, typically in cash or stock. The employee counts this payout as ordinary income upon exercising the SAR, and the employer gets a tax deduction on that date.
When offering equity incentives, tax considerations are key in determining which plan is best for the company. If your startup is cash-poor but idea-rich, you’ll need top talent to implement your company goals. Equity incentives are a practical way of attracting and keeping valuable employees.