What is equity compensation?

Takeaway: Startups usually issue restricted stock awards (RSAs) to early employees while the price of the stock is low enough for them to pay for the shares and options when the price of the stock gets too high for folks to buy the shares outright. Owning shares directly (e.g., RSAs) is typically better for the recipient from a tax perspective.

Equity compensation is a common way for startups to attract and retain talent, incentivizing employees to work hard and contribute to the company's success. Equity compensation can take several forms, including stock options and restricted stock awards (RSAs), and typically vests over a period of time, incentivizing recipients to remain with the company. In this post, we’ll discuss some key features of equity compensation at a startup.

Stock options

Stock options give employees the right to buy a certain number of shares of the company's stock at a set price, known as the strike price or exercise price. Stock options are not stock so the holder does not have voting rights and the long-term capital gains clock does not start running until the option is exercised. Options typically vest over a period of several years and are exercisable for a certain period of time after vesting. When service providers leave a startup, they typically have 3 months form their termination of service to exercise their option; if they don’t exercise within that window, the option expires.

Restricted stock awards (RSAs)

Restricted stock awards are a type of equity compensation that is granted to employees or other stakeholders of a company. RSAs are actually stock (as opposed to an option to purchase stock). They involve the grant of shares of company stock that are subject to certain restrictions or limitations, typically related to vesting criteria. Unlike stock options, when a service provider leaves a startup, they retain the shares of stock that they have vested under their RSA.

Vesting schedules

Equity compensation typically vests over a period of time, often with a one-to-four-year vesting schedule depending on the recipient’s role at the company. This incentivizes employees, consultants, and advisors to remain with the company and work hard to help the company succeed.

Exercise price

Stock options typically have an exercise price that is set at the fair market value of the company's stock at the time the option is granted. This is also called the strike price. This means that the recipient must pay the exercise price in order to purchase the company's stock.

RSAs on the other hand are actual stock purchased by the employee up front. This is why RSAs are common early employee compensation (before the company’s valuation goes up) and options are common later on.

Tax implications

Equity compensation can have significant tax implications for both the company and the recipient. It's important to work with a qualified tax professional to understand the tax implications of equity compensation and to ensure that the terms of the equity compensation are structured in a way that minimizes tax liability.

Conclusion

Equity compensation is a valuable tool for startups to attract and retain talent. By offering a stake in the company, equity compensation aligns the interests of the recipient with those of the company's stockholders, incentivizing employees to work hard and contribute to the company's success.