When it comes to your company’s stock, don’t make early promises to employees and partners that you'll regret as the business grows.
Do employees work harder when they have an equity stake in growth-oriented companies? My view is yes — but you can’t lose sight of your company’s long-term health in an effort to make your employees happy now.
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So here are three ways to motivate using stock, while protecting your business:
Common stock in lieu of compensation
Employees can be “given” shares in lieu of salary or as a bonus for exceptional performance. The advantage of owning stock versus stock options is the employees have what is called “skin in the game” right away.
It’s important to note that while the company may gift the stock to employees, it’s not free to employees. The IRS requires businesses to report all compensation expenses, whether or not provided in the form of cash or stock. With respect to stock awards, even though recipients may not receive cash today for services rendered, the IRS still likes to take its share of compensation for the year that it was "earned." This means the employee has to pay a percentage of the “value.”
Fortunately, to minimize tax burdens for stock recipients, privately held companies have a degree of flexibility in estimating the fair market value of their stock. If the shares are granted at the time of startup and valued at pennies per share, the tax obligation may be negligible. However, if an employee in the 25 percent tax bracket receives stock that is valued at $50,000, then the employee is liable for an extra $12,500 in taxes. Ouch!
Stock options give employees the right to purchase a certain amount of shares in a company at a set price (the “exercise price” or “strike price”) for some period of time. The advantage to employees is they don’t have to risk their own funds. Ideally, they will exercise their stock option when the company’s per-share value exceeds the strike price.
Provided the strike price is equal to the company’s per-share value, the employee doesn’t have an immediate tax obligation at the time of the stock option grant. If all goes well, stock option recipients can sit back and watch a company's per-share value grow above the stock option’s strike price.
There are two primary types of plans: one for employees, called an incentive stock option plan, and another primarily for non-employees, called a nonqualified stock option plan. Incentive stock plans offer the best tax deal to recipients, allowing them to report profits only after they exercise the stock option and sell the shares. Nonqualified stock option holders generally have to pay taxes on their profits a little earlier, at the time the stock option is exercised.
Common stock for purchase
It’s not uncommon for opportunistic employees to ask business owners if they can purchase an equity stake in a growth-oriented business, especially if the company doesn’t offer a stock option plan as an employee benefit. These requests are most easily administered when a company is already raising capital from angel or venture-capital-fund investors. Whatever deal the investors negotiate, the employees get too.
It’s important to note that there’s a cost anytime business owners hand out shares to employees, investors or vendors. While handing out stock can help conserve a company’s cash, every stock grant to employees and other outsiders “dilutes” the size of the entrepreneur’s own equity stake in a business. Over time, entrepreneurs have to watch that they don’t lose voting control of their companies from being too generous with stock awards.
Here are some other fine points of common stock grants that entrepreneurs should know:
- Board of directors' approval. Most corporations require the board of directors to approve all issuances of securities, including common stock awards and stock options. An entrepreneur can offer shares to an employee or vendor, but the deal isn’t sealed until it is approved by the board of directors.
- Vesting issues. Can entrepreneurs get company shares back if an employee or partner doesn’t perform? Not likely. To avoid the angst and bitterness associated with low-caliber employees walking away with a big chunk of stock, entrepreneurs should give stock awards that vest over a period of time or at project completion. That way, entrepreneurs can cancel the unvested shares. For extra protection, spell out the expectations for stock qualification in writing.
I don’t think it is fair, however, for entrepreneurs to expect employees or vendors who take deep salary cuts or cancel debts to receive restricted shares. They’ve provided an immediate, tangible benefit to the company and should receive a restriction-free award for their cooperation and loyalty.
- Tax tricks for vested shares. The IRS allows recipients of restricted stock grants to delay reporting of the income-earning event until vesting restrictions lapse. On the surface, this seems like a benefit to stock recipients — but only if the value of the shares doesn’t increase during the vesting period. Since the final tax bill is pegged to the value of the shares, stock recipients can end up paying a much larger tax bill if they own shares in a fast-growing company.
Fortunately, stock recipients have a choice — they can pay taxes on the entire restricted-share total in the year of the stock grant, or they can wait until the annual restrictions lapse. Timing matters. Stock recipients who bet that the company’s shares will go up in value have only 30 days from the date of the stock grant to complete and send the simple "83(b) election" form to the IRS. States may have some additional requirements, so it is best to get guidance from an accountant.
Using equity as a form of compensation involves compliance not only with tax regulations, but state and federal securities laws as well. But by doing so you’ll have many more individuals celebrating your success when you achieve your entrepreneurial goals.