Equity incentives are a major perk in the startup and tech world. They offer employees a chance to share in the company's success, but navigating the complexities of equity incentives can be tricky. Here are five common mistakes startups and their tech employees make:
1. Mistaking an ISO Grant for Guaranteed ISO Treatment:
It is well known that ISOs have the potential for better tax treatment than NSOs. They also have drawbacks. However, executives are almost always taken off guard when they learn that, just because they received an ISO grant doesn't guarantee that it'll qualify for favorable tax treatment. ISOs can offer tax advantages, but only under certain circumstances and only if they meet the requirements set forth in the Internal Revenue Code. For example, an option holder will never qualify for ISO tax treatment unless he or she exercises and holds the shares for at least one year from the date of exercise (and two years from the date of grant) before disposing of them. So, if the unexercised ISOs are cashed out in a change in control transaction and have never been exercised, the ISOs will be taxed as NSOs. ISOs may also prove less advantageous than anticipated if the option holder is subject to the alternative minimum tax – this is a common issue for high-income earners. And finally, if all the ISO criteria are met, the company loses a tax deduction that would be available if the options were ISOs. This might not seem valuable for a start-up without foreseeable profits, but in the future once there is a profitable business, the lost corporate tax deduction could be very costly to the Company founders.
2. Making Grants to Entities Under a Stock Plan:
Grants to entities (such as LLCs) are often expressly prohibited by stock plans. Special care should also be taken to ensure that the grant is made to the actual service provider to maintain proper tax treatment reporting. For example, if an employee is the actual service provider, a grant should not be made to his family LLC, since the employee is the individual who performed and is being compensated for the services.
3. Skipping Corporate Formalities to Save Money (It Won't):
Some startups, in an effort to save money on legal fees, might neglect proper formalities surrounding stock option grants. This can be a major red flag for VC investors during due diligence. Even in seed rounds, VCs will diligence all option grants and will review board consents to confirm appropriate corporate formalities were observed and that the grants were made on an effective 409A safe harbor, such as in reliance on a 409A valuation. Even more thorough diligence is performed when your company is ultimately acquired. Section 409A of the Internal Revenue Code is a complex, unforgiving piece of legislation, and while the requirements for granting stock options are not necessarily challenging, there are many foot faults for the unwary. Non-compliance with Section 409A can lead to severe penalties. Routinely, “founders who try to “DIY” goof important things like vesting schedules, compliance with securities laws, making grants in excess of the reserved share pool, and issuing equity incentives improperly to international grantees.
4. Forgetting About Section 83(b) Elections:
Future parties performing due diligence will often ask for executed copies of Section 83(b) elections. If these elections are not filed, there can be adverse tax consequences for both the company and the grantee. Failing to file a Section 83(b) election on a large grant of founders stock can be truly disastrous for a fast growing company, causing significant tax and withholding issues for both the company and the founder. A common misconception is that the company doesn't need to maintain records of Section 83(b) elections because it is a personal tax election for the grantee. While this is true to some extent, a requirement of making a Section 83(b) election is that a copy must be given to the entity for whom the services are performed. Therefore, maintaining these records is crucial for compliance and to avoid potential complications during due diligence.
5. Putting Off Equity Grants Until "Later" (Later Can Be Expensive):
Startups sometimes delay granting equity due to a fast-paced environment, or because they are not sure what type of awards to make. Sometimes the company does not want to invest in upfront advisor costs to get help making equity awards properly. This can backfire if the company's valuation increases significantly before the grant becomes official and the intended recipients miss out on the potential for lower exercise prices (in the case of options) or, if restricted stock was originally anticipated, granting restricted stock may no longer be practical because of the substantial tax implications. Consequently, employees might be forced to accept stock options instead, which means that the impacted employees can potentially lose out on significant equity value that they helped generate, and miss the capital gains tax treatment that comes with properly granted restricted stock and a timely Section 83(b) election. This can be demotivating and undermine the original intent of the equity grant.
Protect Your Equity Incentive Journey:
Equity incentives are a powerful tool for startups and tech employees, but navigating the complexities requires knowledge and planning. By understanding these common pitfalls, start-ups and their employees can make informed decisions and maximize the benefits of equity grants.
Remember: This is not a substitute for professional tax or legal advice. For specific guidance on your situation, please feel free to reach out to any of our team members here at Cohen & Buckmann.