Transcript
Equity is one of the most powerful resources a startup has.
It helps you hire when cash is tight. It aligns people with the long-term outcome. And it comes with real legal and tax constraints. For tax and securities law reasons, compensatory equity is issued through an equity incentive plan.
The plan is approved by the board and stockholders and reserves a portion of total equity for the team, often around 10%. Once that pool is used up, increasing it means dilution and approvals. One key constraint, equity under a plan can only be granted to human beings who are providing services to the company.
Equity grants are priced at the fair market value of the company's common stock. Boards usually rely on an independent 409A valuation to set it. As the company grows, fair market value typically rises and financing and other major events can require a new valuation.
That single fact drives many equity decisions.
Options versus stock. Most equity grants are stock options. An option gives someone the right to buy stock later at a fixed price. Until they exercise, they don't own any shares. Employees often receive ISOs, which can have favorable tax treatment if certain rules are met. Contractors and advisers receive NSOs, which are more flexible but generally taxed less favorably.
Restricted stock is actual stock issued and paid for upfront. When the fair market value is low, that can make sense. When the value is higher, options are often the better tool. Vesting and 83b.
Most startup equity vests over time. For employees, that's often four years with a one-year cliff. Vesting can also be performance-based or milestone based and may include acceleration. Creativity is allowed. Clarity is required.
If restricted stock vests, the 83b election matters. It lets the recipient be taxed when value is low. The deadline is strict. Miss it and the tax cost can be significant. Issuing equity in practice.
The company has a plan and reserve shares. The board sets the fair market value. The board approves the grant.
Documents are signed. The cap table is updated. Waiting to paper it later often means a higher fair market value. That hurts the very people you're trying to incentivize. Don't just promise equity. Grant it.
Equity Grants
Equity compensation is one of the most powerful tools available to startups. It allows you to attract and retain top talent, conserve cash, and align your team’s incentives with the long-term success of the company. At Fahner Law, we help founders design and implement equity programs that are both motivating and legally compliant.
Why Equity Compensation Matters
- Talent magnet: Competitive equity packages are often expected in the startup world.
- Cash preservation: Grants help compensate key hires when salaries may be below market.
- Alignment: Employees and advisors share in the upside when the company grows.
Types of Equity Awards
We advise on the full range of equity compensation structures:
- Stock Options
- Incentive Stock Options (ISOs): Available only to employees, with favorable tax treatment if requirements are met.
- Nonqualified Stock Options (NSOs): Can be granted to employees, contractors, and advisors, with more flexibility.
- Restricted Stock Awards (RSAs): Actual shares issued upfront, usually subject to vesting and company repurchase rights.
- Restricted Stock Units (RSUs): A promise of stock delivered in the future, often used by later-stage companies.
- Profits Interests (for LLCs): A way to grant a share of upside growth without current ownership.
Each has different tax, accounting, and administrative implications. We help you select the right mix based on your company’s stage and goals.
Equity Incentive Plans
Most companies adopt an equity incentive plan early on. This plan sets the rules for option grants and other awards, and it must be approved by the board and stockholders. Key elements include:
- Number of shares reserved for awards.
- Eligible recipients (employees, consultants, directors).
- Vesting schedules and acceleration provisions.
- Administration by the board or compensation committee.
Proper board and stockholder approvals are essential for validity and investor confidence.
Securities Law Compliance
Equity awards are securities—and subject to federal and state securities laws. Startups typically rely on exemptions like:
- Rule 701: The most common exemption for private company equity awards.
- Rule 506(b): Often used for awards to executives and directors when Rule 701 limits are exceeded.
Failure to comply can expose the company to rescission claims, regulatory enforcement, or jeopardize future financings. We ensure your grants are structured to fit within the right exemptions and state “blue sky” rules.
Tax Considerations
Equity awards can trigger both income tax and employment tax. Key issues include:
- Exercise price: Options must be priced at or above fair market value to avoid adverse tax consequences (Section 409A).
- 83(b) Elections: Founders or employees who receive stock subject to vesting should consider filing an 83(b) election to lock in a low tax basis and start the capital gains clock. (See our Formation page for more detail.)
- Withholding obligations: Companies may be required to withhold and remit taxes when awards vest or are exercised.
Best Practices for Administering Equity
- Keep your cap table updated and accurate.
- Obtain regular valuations (409A appraisals) to support option pricing.
- Document every grant through board/committee approvals, agreements, and updated ledgers.
- Deliver all required plan and grant documents to recipients.
- Track vesting, expirations, and exercises with a reliable system.
How Fahner Law Helps
We provide end-to-end support, including:
- Drafting and adopting equity incentive plans.
- Preparing option, restricted stock, and profits interest agreements.
- Ensuring compliance with securities and tax laws.
- Helping you stay investor-ready with clean documentation and recordkeeping.
FAQs
What’s the difference between ISOs and NSOs?
ISOs are for employees only and can offer favorable tax treatment if held long enough. NSOs can be issued to anyone but are taxed as ordinary income on exercise.
When should I adopt an equity incentive plan?
Most startups adopt a plan right after formation—before making their first key hires. Investors will expect one to be in place.
Do I need a valuation before granting options?
Yes. A 409A valuation (or equivalent) is required to set a defensible fair market value and avoid tax penalties.
Can contractors receive equity?
Yes, usually through NSOs or restricted stock. However, securities law exemptions and tax treatment differ, so careful structuring is required.
What happens if we don’t comply with securities laws when granting equity?
You may face rescission claims, regulatory penalties, or issues in future financings or exits. Compliance is critical from the start.
Do employees pay tax when options are granted?
No, typically not. Tax usually arises when options are exercised or when restricted stock vests (unless an 83(b) is filed).
Build, grow, & exit with confidence.
Thinking about granting equity to your team?
Fahner Law offers flat-rate equity packages covering plan adoption, grant documents, and compliance guidance, so you can reward your team and protect your company.