It’s common for startups to look for talented and experienced employees who can play a big role in taking the business to the next level. Startups need people who can build businesses. However, what is also common is that in the initial stages of business, these companies do not have a lot of cash to dole out higher salaries. They can offer equity instead, but the rights in such equity will be given gradually to the employee so that the employee does not get hold of the shares and leave. This is the idea behind stock options.
For example, here’s how a vanilla stock option grant would work:
Grant date: 30 August 2021, No. of stock: 1000, vesting period: 4 years, cliff period: 1 year
In this case, the employee will have a right to be allotted the stock as under:
- 30 August 2022: Nil
- 30 August 2023: 250
- 30 August 2024: 250
- 30 August 2025: 250
- 30 August 2026: 250
In addition to the vanilla stock option where equity shares are vested in an employee over a period of time, there are a lot of permutations and combinations which people have arrived at, based on the sectors, the needs of founders, tax treatment etc.
- If you actually want to give the ownership stock to your employees, you can choose to grant Equity Stock Options, Sweat Equity, Restricted Stock Awards (RSAs) or Restricted Stock Units (RSUs) or use ESPPs – Employee Stock Purchase Plans.
If you simply want to give the value of the appreciation in the stock without actually granting the stock, you can choose to grant Phantom Stock Options or Stock Appreciation Rights.
2. Statutes in different countries can be taxing the stock options differently. For the purpose of this write-up, we will focus on tax treatment for stock options in the US. From a tax perspective, the stock options can be divided into Incentive Stock Options (ISOs) and Non-Statutory Stock Options (NSOs).
Let’s look at these in a little more detail:
- Where your employees actually get the shares vs. where they receive only the value of the appreciation
In a vanilla stock option scheme, as we already saw in the example, your employees will receive actual equity shares, although this will be in a staggered manner and upon payment of an exercise price.
Similarly in a Restricted Stock Award (RSA), the employee is actually granted the equity shares, but the rights in such shares as an owner do not vest until a certain period has elapsed. Basically, the employee cannot sell such shares and benefit from the capital appreciation until they have vested. After they have vested also, the employee needs to pay a ‘purchase price’ in order to get the full rights in the shares.
This is used when you do not want to go through the formalities of the employee being given an option certificate first, then exercising it and then getting the shares. The shares are directly allotted here, just the rights are restricted.
Restricted Stock Units (RSUs) on the other hand are closer to what can be called ‘sweat equity’. The shares are allotted to the employee according to a vesting schedule and they do not have to pay anything for the shares except for the taxes.
In this scheme also there are no óptions’or option certificates which are given, but the shares are directly allotted in a staggered manner according to a vesting schedule.
Employee Stock Purchase Plans (ESPPs) are when the employees can purchase the shares of a company at a discount. The payment for the shares can even be made by deductions from the salary between the date when the shares are offered and when they are actually purchased.
In this method, the shares are granted and the rights to the shares are also granted simultaneously, but because of that, the discount is quite low (about 10%) and the employee will be paying for the shares like an external investor. In India, this kind of offering would be made as a part of an issue of the company, where the employees are offered the shares at a discount compared to the other investors in an issue.
As you can see, the above schemes do result in the employee holding ownership rights in the company through equity shares, but none of them grants instant ownership over the shares at a heavy discount. It is always over a period of time, to ensure that the employee remains interested in the growth of the company.
However, there can be schemes that never result in the employee holding any equity in the company and yet benefitting from the capital appreciation. This is what happens in Phantom Stock Options or Stock Appreciation Rights.
In both these schemes, there is a notional grant of shares to the employee and they are entitled to the difference in the value of the shares of the company when they were granted the shares vs. when there is an ‘éxit event’.
For example, if Andy is granted 100 options today under a Phantom Stock Option scheme, he will never actually receive the shares. But if the value of the shares is $100 today (at $1 per share) and after some period, there is an event where the founders sell their shares to an investor at $1.5 per share, Andy will receive $50 – the appreciation in the value of his holding.
How to choose between the two?
Schemes that do not grant any actual shares to the employees work well for founders who do not want to give voting rights in the decisions of the company and yet want the employees to benefit from capital appreciation.
For those founders who want the employees to be involved in the decision making in the company, schemes granting them actual equity shares or stock works well. Remember that you can always restrict the total number of shares the employees can hold in the company (called an option pool). So there will never be a situation where the founders or investors are minority shareholders and employees hold the majority of shares and call the shots.
- The difference in the tax treatment of stock options – Incentive Stock Options (ISOs) and Non-Statutory Stock Options (NSOs)
In order to qualify as ISOs or incentive stock options, there are certain specific conditions that must be met, in respect of the scheme and the vesting and exercise of the stock options.
The basic idea behind a favourable tax treatment for these stock options is that these are granted to the employees only and not to the founders (these cannot be granted to individuals who hold more than 10% of total voting power) and these are also not used for advisors, consultants etc. The restrictions or qualifying conditions can be seen here. Some important restrictions for options to qualify as ISOs are:
- The shares obtained by the exercise of these options are not to be sold until at least two years from the date of grant and one year from the date of exercise.
- The option price is not lesser than the fair market value of the shares at the date of grant.
- The aggregate fair market value of shares exercisable by ISOs in any calendar year cannot exceed USD100,000. This is actually the biggest limitation because the company would have to make the grants accordingly, otherwise, any additional exercises beyond this amount would be classified as NSOs.
The favourable tax treatment for ISOs is simply that there is no taxation at the time of grant or exercise or right until the time when the shares received upon the exercise of the stock options are actually sold. When they are sold, if they have met the holding conditions written at point 1) above, the gains on the sale are taxed as long term capital gains. These are applicable in different slabs of 0%, 15% and 20% depending upon whether you are single, married and filing taxes individually or jointly or if you are head of the household (see here).
On the other hand, Non-Statutory or Non-Qualified Stock Options are taxed twice i.e. once at the time of the exercise and other times, at the time of the sale of the shares received upon the exercise of the stock options, although the tax treatment can be different at both the times.
There is no taxation on grants or vesting of the non-statutory stock options. However, when you exercise the options, you get taxed on the difference between the exercise price and the fair market value of the shares of the company. The tax rates applied are the ordinary tax rates that you pay on your income.
This is useful to the company because the company gets to deduct this amount as if it were a salary paid to you. The company withholds a certain amount of tax on this notional payment and you would need to pay the balance at the time of filing your return.
Now when you actually sell the shares which you had received by exercising, if your sale amount is higher than the notional profit you paid taxes on, you pay the taxes on the difference. If you have exercised the options at least 12 months before the sale, you are taxed at the long term capital gains rates. If not, even this additional profit will be taxed at your normal income tax slab rates.
For example, if you are granted 100 stock options and at the time of exercise, your strike price is $1 but the fair market value of the company’s shares is $3, you would pay taxes on the notional profit of $200 [100 ($3-$1)] at your normal income tax slab rates at the time of the exercise.
Now if you hold the shares for at least a year after the exercise and sell them afterwards for $500, you will now be taxed for long term capital gains on $200 ($500-$300, the notional value at which you paid taxes earlier).
How to decide between the two?
ISOs may work well for an employee, but the overall restriction of $100,000 for a calendar year can become difficult for a company to maintain. It also depends upon to whom the company wants to grant the options. ISOs can only be granted to employees. Therefore, if the company wants to involve founders, advisors, consultants etc., it has to grant NSOs.
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