The Shadow CEO is an ongoing series with tips for entrepreneurs from serial founder and high-tech industry veteran Dennis Cagan, who has served on sixty-seven for-profit corporate boards, including ten publicly traded companies.

Many first, second, and even third-time founders get themselves into bad situations that could be avoided if they knew more about how corporate governance and equity distribution worked in early-stage companies.

Whether you hope to eventually sell your start-up to a larger firm or navigate through an IPO, if you plan on taking in investors—friends and family, angels, venture capital, or strategic corporate investors—you need to understand how to protect yourself and your management team.

The segments in this ongoing series can not only save you time and energy, but they could result in making—or saving—you millions of dollars.

Equity distribution techniques

An employee owning equity in a large well-established public company usually considers it as part of their pay—albeit deferred. In a big company, it’s usually dispersed on a standardized, regularly scheduled basis. The amount is normally determined by things like the level of employment, tenure, and performance, and it’s fairly uniform across employment categories. The equity is typically in the form of stock options, but it also comes in several other forms.

Equity incentives can be structured and offered in much the same ways by an LLC (although it can be more complicated for an LLC because they are contract-based, regulated primarily by IRS rules, whereas corporations are State statute-based, and regulated primarily by Secretaries of State and the SEC).

Equity distribution in an early-stage venture is slightly different from a more established company. While there are guidelines, metrics, and strategies for allocating incentive equity to individual, on day one in a startup there is nothing to guide the process. As the company matures—hopefully guided by some experienced professional advice—the standards, goals, and processes begin to be more established and consistent.

Equity Incentive Plan

The instrument most frequently used by corporations to distribute equity to employees and other contributors is commonly termed an Equity Incentive Plan (“EIP”), or simply a stock option plan. These plans represent a significant document—generally twenty to thirty pages. They all follow similar guidelines and formats. When properly constructed they adhere to specific IRS regulations (qualified plan) that allow for the more favorable tax treatment of any eventually recognized gains that the individual may get whenever they exercise the option to buy the shares, and ultimately sell the underlying stock.

The adoption of an EIP almost always requires the approval of the board. The adoption of such a plan then allows the board to allocate a certain amount of company stock to a pool within the EIP. Then as management assesses its alternatives for compensating individuals, it submits their names and amounts to the board for approval. This submission normally goes to the board’s compensation committee if one has been established.

The requested stock or option grants include details in addition to the number of shares, including strike price, vesting schedule, term, and exercise period. At the time the board approves these grants, it sets the shares’ fair market value (“FMV”). Once approved, the grants—whether options, RSUs (restricted stock units), restricted shares, or others—are documented by management. The documents are then sent to the grant/award recipients. These documents include a copy of the EIP, a grant notice (informing the awardee of the specifics of their grant), and perhaps a Shareholders Agreement and an IRS Form 83(b) (more on this later), which the individual must sign and return.

Stock Options

Options are the most common type of equity compensation granted by companies to their employees and executives. Rather than granting actual shares of stock directly, the company grants an option to buy a share, at some later date, at a price per share—termed strike price—that must be set by the board at what they determine to be the current FMV of each share—in a private firm the board sets the price. In a publicly traded company, the price is the actual stock market price at the end of the day the grant is awarded. Clearly, on the grant date the option is worth nothing—since your strike price is the same as the value at that time. However, everyone hopes that over time the FMV of the shares will increase, even to the point of an IPO (initial public offering). At that time vested options can be exercised—at the original strike price—and then sold at the higher market price.

Here are the key considerations:

• If these options are for an early-stage private company, even if the option were ‘exercised’ and the share was purchased, there is usually no market — no one who will buy the share. There will also likely be restrictions for selling anyway.
• When options are awarded, there is normally a ‘vesting’ schedule. This means that your options only become vested or exercisable over time.

Incentive Stock Options

Incentive stock options (ISOs) qualify for special tax treatment under the Internal Revenue Code and are not subject to Social Security, Medicare, or withholding taxes. However, to qualify they must meet rigid criteria under the tax code. ISOs can only be granted to employees, not to consultants or contractors. There are also other considerations for the exercise of options and the sale of the shares. Also, there are additional rules set by the company and the IRS for the exercise of the options, including an option term and an exercise period after termination of employment. ISO taxation is complex. You must understand how the code works when you exercise, including alternative minimum tax (AMT).

After you exercise ISOs, if you hold the acquired shares for more than two years from the date of grant and more than one year from the date of exercise, you incur favorable long-term capital gains tax (rather than ordinary income tax) on all appreciation over the exercise price. However, the paper gains on shares acquired from ISOs and held beyond the calendar year of exercise can subject you to the AMT. This can be problematic if you are hit with the AMT on theoretical gains, but the company’s stock price then plummets, leaving you with a big tax bill on income that has evaporated.

Example: A W-2 employee might be granted 3,600 common stock options, at a strike price of $0.15 each, and the award vests monthly over three years (there are also a variety of other vesting details). This means that each month 100 options vest and could be exercised — in which case at the end of month one, the employee might pay the company $15.00 and buy those 100 common shares.

It is the norm that options are not usually exercised until the stock can be sold, however, all grants have an exercise period that triggers when the employee quits or is terminated. These periods can vary from 30 days up to five years. The norm is usually 90 days. If the individual is an employee, and the options were granted under an IRS qualified plan, they are considered incentive stock options (ISOs), which offer some tax benefits. If the individual is not an employee, for example, a board director, contractor, advisor, or consultant, companies usually grant nonqualified stock options (NQSOs). An NQSO does not qualify for special favorable tax treatment under the U.S. Internal Revenue Code.

Thus, the word nonqualified applies to the tax treatment (not to eligibility or any other consideration). For IRS purposes, the difference between the strike price and the eventual selling price of each share is taxed. If the options were exercised and the shares were held for a minimum of one year, the proceeds qualify for long-term capital gains. If the shares are held for less than one year, it is ordinary income.

With a NQSO the taxes are due for the calendar year in which the options are exercised, based on the difference between the strike price and the current FMV, and then taxed again when the shares are sold, for the balance of any gains that were not previously taxed. With an ISO, the option can be exercised with no tax due, and the full gain is then taxed when the shares are finally sold.

Example: Your stock options have an exercise price of $10 per share. You exercise them when the price of your company stock is $12 per share. You have a $2 spread ($12 — $10) and thus $2 per share in ordinary income. Your company will withhold taxes—income tax, Social Security, and Medicare—when you exercise NQSOs. When you sell the shares, whether immediately or after a holding period, your proceeds are taxed under the rules for capital gains and losses. You report the stock sale on Form 8949 and Schedule D of your IRS Form 1040 tax return.

As noted above, there are several key elements, or variations, to stock option grants. These should be clearly laid out when the grant is approved by the board and stated in the grant notice to the awardee. Of course, the number of shares, and the FMV strike price, as determined by the board, are required.

Next, there will be a defined vesting schedule — the time or conditions under which the options vest. Variations here may include straight time-based vesting — like monthly, quarterly, or annual vesting, normally over a period of up to four or five years. Companies may also award grants with what is called a ‘cliff.’ This means that there is no vesting — for an initial period of time, say six months or a year (e.g., an employee probation period), then after that period all the options that would have vested, are vested retroactively. There is also the actual term of the grant itself — usually defined by the EIP. After that period — often five to ten years, the EIP itself expires, and must be replaced by another.

Another very important term is the exercise period. This defines the amount of time the awardee has after their termination (voluntary or not) to ‘exercise’ their options and purchase the shares by paying the strike price to the company. If they fail to exercise within that time, the options expire — gone. Why would this happen? Several reasons. For example: they forget (this does not usually happen if the exercise period is 30-days or even 90-days, but if it’s longer, perhaps), or if at the end of the exercise period, if you cannot sell the stock, and cannot afford to pay the combined strike price or the taxes. Most commonly, the strike price is simply higher than the FMV — this is called being ‘out-of-the-money’ or ‘underwater’. Therefore, you would have to pay more for a share than it was worth at that time.

There is one more potentially important term called change-of-control. This provision stipulates that if there is a change in control of the company — usually defined as majority ownership shifting from one individual or organization to another like if the company is sold, some percentage (or perhaps all) of the options automatically vest. For example, if one got a grant of 24,000 options, vesting monthly over two years (usually stated as 1/24^th per month), and this grant has a 50% chance of control provision, and the company is purchased by another firm ten months after the grant. These options would have been vesting at 1,000 per month. Ten months would have vested 10,000, leaving a balance of 14,000. A change-of-control of 50% would mean that 50%, or 7,000 of the 14,000 remaining options, would accelerate automatically and be vested, for a total of 17,000. This provision is usually used to protect selected employees, and make sure they continue to contribute even if some liquidity event is on the near-term horizon.

Note: The information provided in this article does not, and is not intended to, constitute legal or tax advice; instead, all information, content, and materials available below are for general informational purposes only.  Information in this article may not constitute the most up-to-date legal, tax, or other information. Readers should contact their attorney or CPA to obtain advice with respect to any particular matter. The views expressed here are those of the author writing in his individual capacity only.

Part 6 of this series will continue with the discussion of restricted shares, RSUs, stock classes, IRS Form 83(b), and more.

MORE SHADOW CEO

PART 1: Early-Stage Insights for Entrepreneurs

PART 2: Deciding to Distribute Startup Equity? Here’s a Founder’s Guide

PART 3: Using Equity as an Incentive and the Role of the Board

PART 4: What Entrepreneurs Need to Know About the Foundational Documents of a Corporation

PART 5: Equity Distribution Techniques

PART 6: Equity Beyond Stock Options

PART 7: Stock Classes and Raising Capital

PART 8: Determining Startup Value

PART 9: Explaining Common Metrics

PART 10: Calculating Share Price

PART 11: Protecting Founders and Special Voting Preferences

PART 12: Additional Equity Grants

About the author:
Dennis Cagan, a noted high-tech entrepreneur, executive, and board director, has founded or co-founded more than a dozen companies and served as CEO of both public and private companies. The venture capitalist, private investor, author, and consultant, is a long-time board member of some 67 corporate fiduciary boards. In his Shadow CEO® role, he steps in side-by-side with a CEO to help them navigate circumstances and situations on a day-to-day basis.

A version of this column was previously published in Cagan’s “A Primer on Early-Stage Company Equity.”

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