Equity compensation is a great way to reward your employees, retain talent, and get more investment in your company. It’s also a complex topic with an ever-changing landscape of rules and regulations. Having an understanding of equity compensation for private companies can help you make informed decisions about how to best incentivize and motivate your employees. This blog post will provide an overview of what private company equity compensation is, the various types available, and the benefits and risks associated with it. We’ll also discuss how to set up an equity incentive plan for your company. By the end, you’ll have a better understanding of what private company equity compensation entails so you can decide if it’s something that fits within your business model.
Private Equity Compensation 101
What are stock options and what is the difference between NSOs and ISO?
Stock options are oftentimes offered by a company to its employees as part of their total compensation. They give the holder the right to purchase shares of the company’s stock at a specified price (known as the “strike price”), usually at a discounted rate, within a specific period of time. The idea behind offering employees stock options is to align the interests of employees with those of the company’s shareholders, and to provide an incentive for employees to work harder and stay with the company. Stock options are typically granted to employees as part of their employment package, and they may vest (become exercisable) over time, based on the employee’s length of service or the achievement of certain performance goals. There are two main types: NSOs and ISOs.
NSOs (non-qualified stock options) are the most common type of stock option given to employees. They are called “non-qualified” because they don’t meet the government qualifications for special tax treatment. When an NSO is exercised, the employee pays income tax on the “bargain element” (the difference between the strike price and the market price of the stock at the time of exercise). The company does not get a tax deduction for NSOs.
ISO (incentive stock options) are a type of employee stock option that gets special tax treatment. The benefit of an ISO is that no income tax is due at exercise. Instead, when the shares are eventually sold, any increase in value over the strike price is taxed as long-term capital gains. To qualify for this treatment, certain rules must be met, including a holding period requirement.
So, the main difference between NSOs and ISOs is that ISOs receive more favorable tax treatment than NSOs. With an NSO, you pay income taxes on the difference between the strike price and market price at exercise. With an ISO, you may not have to pay taxes at exercise, but you will pay capital gains taxes when you sell your shares (assuming they’ve gone up in value).
What is alternative minimum tax and how does it relate to ISOs?
The alternative minimum tax (AMT) is a federal tax imposed on certain taxpayers with high incomes. The AMT is designed to ensure that these taxpayers pay at least a minimum amount of tax.
ISOs are subject to the AMT, which means that you may have to pay more tax on your ISOs than you would on other types of stock options. When you exercise an ISO, you will first owe regular income tax on the difference between the exercise price and the fair market value of the stock. You will then owe AMT on the difference between the exercise price and the “AMT basis” of the stock. The AMT basis is generally lower than the fair market value, so you will end up paying more tax on your ISOs than you would on other types of stock options.
What is a 409a valuation?
A 409A valuation is a tax compliance valuation method for determining the fair market value of the company equity. The Internal Revenue Service (IRS) requires this type of valuation for companies that want to offer stock options and other types of equity compensation to their employees.
A 409A valuation must be performed by a qualified independent appraiser, and it must take into account all relevant factors, including the company’s financial condition, projected future earnings, and the nature of the business. The appraisal must also consider the market value of similar businesses in order to come up with a fair market value for the subject company.
Once a 409A valuation is completed, the company can then grant private company stock options and other forms of equity compensation to employees at or below the appraised value. This ensures that the employees are not being overpaid for their options, and it also protects the company from liability if the options are later exercisable at a price above fair market value.
What are RSUs?
RSUs are a type of equity compensation used by private companies to reward and incentivize their employees. RSUs are essentially an equity grant from the company you’re employed by but you can’t sell until you meet certain conditions. Unlike stock options, which give the holder the right to purchase shares at a set price, RSUs give the holder the right to receive shares of the company’s stock at a future date.
RSUs are often subject to vesting conditions and a vesting period, such as remaining with the company for a certain period of time or achieving certain milestones. Vesting conditions ensure that employees remain with the company long enough to contribute to its success and are not simply rewarded for past performance.
Upon vesting, RSUs typically convert into shares of the company’s stock and are distributed to the employee which for tax purposes will be taxed as income (state, city, local and federal income taxes + Medicare and Fica taxes). The employee can then sell these shares, hold onto them, or use them to exercise other equity-based compensation arrangements, such as stock options.
While RSUs are less common than stock options in private companies, they can be a valuable tool for attracting and retaining top talent. If you’re considering offering RSUs to your employees, be sure to consult with an experienced attorney to ensure compliance with securities laws.
What is phantom stock and how does it work?
Phantom stock is a type of equity compensation where employees are given the right to receive a cash or stock bonus equal to the value of a specified number of shares of the company’s stock, but without actually receiving the underlying shares.
The value of the phantom stock is typically tied to the value of the company’s real stock, and the employees are awarded cash or stock bonus based on that value. For example, if an employee is granted 100 phantom shares, and the company’s stock is worth $50 per share, the employee would receive a cash or stock bonus of $5,000 if the phantom shares are settled in cash.
Phantom stock is similar to stock options in that it aligns the interests of employees with those of the company’s shareholders, and provides an incentive for employees to work harder and stay with the company. However, unlike stock options, phantom stock does not require the employee to purchase the shares at the strike price, and does not dilute the ownership of existing shareholders.
Phantom stock plans are generally less complicated than stock option plans, but they are less flexible. Phantom stock plans have to be established at the beginning and the terms are set, and cannot be changed.
What are the biggest problems with Phantom Stock?
There are several potential drawbacks to using phantom stock as a form of equity compensation:
- Complexity: Phantom stock plans can be complex to set up and administer, and may require the assistance of legal and financial professionals.
- Lack of ownership: Employees who receive phantom stock do not actually own any shares of the company’s stock, and therefore do not have voting rights or other shareholder privileges.
- Limited flexibility: Phantom stock plans are generally less flexible than stock options plans. Once the terms of the plan are established, they cannot be changed.
- Limited liquidity: Phantom stock plans may not be as liquid as other forms of equity compensation, such as stock options or restricted stock units, which can be bought and sold on the open market.
- Potential tax issues: Phantom stock plans can have tax implications for both the company and the employees. For example, if the plan is settled in cash, the employee may be subject to ordinary income tax on the value of the phantom shares.
- Limited use of the funds: Employees that receive the cash or stock bonus from Phantom stock, will not be able to use the funds as they please. They may be restricted to use the funds in certain ways or for certain purposes, such as investing in the company’s stock or using the funds for retirement savings.
It’s important to consult with legal and financial professionals before setting up a phantom stock plan to ensure that it is the right choice for your company, and that the plan is structured and administered in a way that complies with all relevant laws and regulations.
Are there any risks to owning private equity?
In fact, yes, there are. First of all, if you own Incentive Stock Options and you exercise them, thereby purchasing the company stock, you may owe alternative minimum tax on the difference between the predetermined price and the share price the following April after your exercise date. This can be huge because you can’t sell your stock on the secondary market (your shares are private like the company shares of public companies) to pay the tax obligation and the tax obligation could be massive. Before exercising your ISOs, talk to a tax advisor or a Certified Financial Planner like those at Progress Wealth management.
The only way to avoid this risk is to exercise in the same year as a liquidity event where the company offers to buy your stock from you or they decide to become a public company via an initial public offering and the market will buy your shares. This is why many people either wait to exercise their ISOs or exercise them when the spread between the fixed price they can purchase at and the 409a value is less so the AMT obligation is lower (during a bad time in the economy or very early in the life of the startup).
There’s risk with those two options as well because you’re betting on the company’s overall success and the fact of the matter is, for an early stage company, you could be wrong. Startup companies fail all the time and your private stock options may be worthless so be careful.
How to get the most out of your equity compensation: Negotiate
If you’re lucky enough to have equity compensation at your private company, there are a few things you can do to make sure you get the most out of it.
First, make sure you understand the offer.
Figure out the answer to questions such as:
- What kind of equity are you being offered?
- How much is it worth?
- What are the vesting requirements?
Once you understand the offer, it’s time to negotiate.
If you’re not happy with the initial offer, don’t be afraid to ask for more. Equity is a valuable commodity, and you should make sure you’re getting what you’re worth. Finally, once you’ve negotiated a fair deal, make sure you keep track of your equity. Keep an eye on the value of your shares and monitor your vesting schedule so you know when you’ll fully own them. By following these tips, you can maximize the value of your equity compensation and secure a bright future for yourself at your private company.
How to get the most out of your equity compensation: Evaluate
Whether it’s stock options, restricted stock units (RSUs), or something else, it’s important to understand how your compensation works and what it’s worth. One of the best ways to do this is to have your equity compensation evaluated by a financial advisor that specializes in working with tech employees like Progress Wealth Management. A good advisor can help you understand the current value of your equity and how it may change in the long run. They can also help you develop a plan for how to best use your equity to achieve your financial goals.
Here are a few things to keep in mind when evaluating your equity compensation:
1. What type of equity do you have?
Stock options, RSUs, and other types of equity compensation all have different rules and tax implications. It’s important to understand the difference between them so you can make the most informed decisions about your finances.
2. When can you sell your shares?
With stock options, you typically have to wait until the company goes public or is sold before you can cash out. With RSUs, you may be able to sell your shares as soon as they vest. Understanding when you can sell your shares is important for planning purposes.
3. What are the risks and rewards?
Like any investment, there are risks and rewards associated with owning equity in a private company. It’s important to understand both before making any decisions about selling
How to get the most out of your equity compensation: Tax Optimized Sales
If you’re like most people, you probably want to maximize the value of your equity compensation. Here are some tips to help you do just that:
1. Sell when your company’s stock is doing well. Obviously, you’ll want to sell when the stock price is high in order to get the most money for your shares. However, you also need to be mindful of the tax implications of selling. If you sell too early, you may be subject to capital gains taxes.
2. Hold onto your shares for at least a year. If you hold onto your shares for at least a year, you can take advantage of the long-term capital gains rate, which is lower than the ordinary income tax rate. This can save you a significant amount of money in taxes. Tax consequences of selling within the first 12 months after exercise or within the first 2 years following the time of grant result in you paying short-term capital gains on the difference between your predetermined purchase price and the sale price. This could be massive. By waiting just a little longer, you may only owe 20% taxes (or less).
3. Consider using a broker that specializes in equity compensation sales. These brokers can help you navigate the complex world of taxation and ensure that you minimize your tax liability.
4. Stay up-to-date on tax laws and regulations. The tax landscape is constantly changing, so it’s important to stay up-to-date on the latest changes that could impact your equity compensation. This will help ensure that you’re taking advantage of all the available tax breaks and minimizing your liability as much as possible.
How to get the most out of your equity compensation: Maximize tax-saving opportunities
If you’re like most people, you’re probably not an expert on tax law. But when it comes to your equity compensation, it pays to understand the basics of how taxes work. With a little knowledge, you can minimize your tax bill and maximize the value of your equity compensation.
Here are a few tips to consider that may help you get the most out of your equity compensation:
1. Understand the difference between ordinary income and capital gains.
Your equity compensation will be taxed as either ordinary income or capital gains, depending on how it’s structured. Ordinary income is taxed at your marginal tax rate, which could be as high as 39.6%. Capital gains are taxed at a lower rate, which is currently 20% for most taxpayers.
2. Consider exercising your options early.
If you have stock options, you’ll have to pay taxes on the difference between the strike price (the price at which you can buy the stock) and the fair market value of the stock when you exercise your options. The sooner you exercise your options, the lower your tax bill will be.
3. Hold onto your shares for at least a year after exercise and 2 years after grant
If you sell your shares within a year of receiving them, you’ll pay taxes at your marginal tax rate on the entire sale proceeds. However, if you hold onto your shares for at least a year before selling them, you’ll only pay taxes on the portion of the sale proceeds that represents your capital
Private company equity compensation is an attractive option for new employees as it has the potential to increase their overall wealth. It’s important to understand the different types of private company equity, how these benefits are taxed, and what type of risks you might be taking on when accepting a package like this. With a balanced understanding of all factors involved in these packages, companies and their employees can create mutually beneficial relationships that will pay off over time.