An equity incentive plan is a key cornerstone in most startups. Also known as stock option plans, these set a structure for dividing equity interest among employees, partners, and others involved in the business. When laying the foundation for a new startup, entrepreneurs need to consider the various types of equity incentives and determine which ones make the most sense for their business. However, designing and implementing an equity incentive plan can be a complicated process. At the Ferlito Law Group, our corporate lawyers help startups and other companies with all aspects of forming and running a business, including equity incentive plans.
What Are Equity Incentives?
Also known as equity compensation, equity incentives are a form of non-cash compensation offered to employees. An equity incentive plan allows a company’s employees to share in the profits of the business. These incentives are offered as one piece of a larger compensation package, along with salary and benefits. In some situations, offering a favorable equity incentive plan may allow a business to offer a below-market salary.
Many public and private companies offer equity incentive plans, but they are especially popular in the startup world. Emerging startups are often short on cash and unable to offer high salaries, while other entrepreneurs may prefer to invest their cash flow into growing the company. An equity incentive plan allows startups to attract highly qualified employees. While there is no guarantee that an equity stake will yield profits, high-quality candidates are often willing to work for lower salaries in exchange for an equity incentive plan.
The Benefits of Offering Equity Incentives
Equity incentive plans can be beneficial both for the ownership of a startup and its employees. A well-designed plan will benefit the company by allowing it to hire the qualified employees it needs to succeed, while the employees can benefit by purchasing stocks that can be expected to increase in value if the company does succeed. Additionally, implementing equity incentive plans as parts of compensation offers allows startups to use their early-stage cash in areas other than labor, such as purchasing equipment.
Equity incentive plans also incentivize employees to produce at a high level, as the success of the company is directly linked to the potential profits of their equity incentives, such as stock options. These plans can help build loyalty among employees and instill the team with a sense of purpose, as they can expect their hard work to yield financial rewards beyond their salary.
Common Types of Equity-Based Incentives
Equity incentives may include a variety of investment vehicles that offer employers a stake in the ownership of the company. Common incentives added to equity incentive plans include stock options, restricted stock, and performance shares.
Companies can offer employees basic stock options at a predetermined price, also known as an exercise price. The company has the option to make these options vested, which means that employees are awarded control of their options after working for the company for a designated period. The employees are granted the right to sell or transfer the option when it vests. These stock options usually have an expiration date.
Employees who are awarded these stock options are not considered stockholders and do not have the same rights as shareholders. There are also different tax rules for vested versus unvested stock options. According to the Bureau of Economic Analysis, employees who exercise stock options incur tax liabilities equal to the difference between the market and exercise price. The company receives a tax deduction for that same difference.
Non-Qualified Stock Options (NSOs)
Non-qualified stock options are one of the most common types of equity incentives, as they are simpler than other types of stock options. NSOs are employee stock options that allow recipients to pay standard income taxes on the difference between the grant price and the price at which the employee exercises their option.
Employees are granted the right to buy a predetermined number of shares at a preset price, within a designated period. The price of these shares is usually the same as the market value of the shares when they are made available. If the employee does not exercise their option within the designated timeframe, they lose their options.
Incentive Stock Options (ISOs)
While NSOs are taxed as ordinary income, the profit on qualified incentive stock options is taxed at the lower capital gains rate. Employees have the right to buy company stock at discounted prices, along with receiving tax benefits not included with NSOs. Incentive stock options are typically awarded to the company’s top management and highly valued employees. ISOs have a required vesting period of at least two years and a holding period of over a year before they can be sold.
After an employee exercises an ISO, their employer should provide them with Form 3921, Exercise of an Incentive Stock Option Under Section 422(b). This form helps determine the amount that the employee needs to report on their Internal Revenue Service tax return.
A restricted stock option requires a vesting period, which can be completed all at once or over a designated period. Vesting can also be completed equally over a set period of years. Companies have the option to draw up any combination that suits their company. Restricted stock benefits the company in some ways, but employees do not have any stock ownership rights until they have earned their shares.
Performance shares are awarded based on specified performance metrics, such as targets for earnings per share, return on equity or the total return of the startup’s stock compared to an index. Performance periods are usually set on a multi-year schedule. In most situations, performance shares are only offered to managers and executives as an incentive to improve the shareholder value of the company.
Learn More From the Experienced Business Lawyers of the Ferlito Law Group
Equity incentive plans allow startup founders to attract high-quality employees that can help their business grow and succeed in the marketplace. However, entrepreneurs should be aware that there are a variety of complicated tax and legal matters involved with equity incentives. Determining which incentives best suit your company and how to best implement your plans can be difficult, especially for first-time startup owners.
At the Ferlito Law Group, our team of dedicated New York corporate attorneys helps our clients with equity incentive plans and all other aspects of running a successful startup. Contact us today to learn more about how we can help your business.