Comparing Startup Stock and Taxation

finance and tax Apr 10, 2024

Five Common Types of Startup Equity Given as Compensation

Most early-stage startups can't afford to pay market-rate salaries to their employees and contractors. Startups usually provide equity to their workers to make up for the underwhelming (and sometimes non-existent) cash compensation. Many startup veterans and financial planners have written extensively about startup stock options, so I'll assume you have a basic understanding of how they work. If not, this article provides a very brief explanation.

Unfortunately, most writers only focus on stock options granted to employees. What if you want to give stock options to non-employees? Are there other types of equity that you can grant? And how is each type of equity treated from a high-level tax perspective?

This cursory blog is meant to summarize a lot of research to help founders, employees, and contractors understand how the five types of startup equity below are used to compensate workers:

Incentive stock options
Non-qualified stock options
Restricted stock awards
Restricted stock units
Warrants

Build a Plan to Address Tax Implications of Your Startup Equity

Many recipients of startup stock never take the time to understand and plan for taxes should the startup blossom and their equity becomes quite valuable. I’ve spoken with many founders and employees who were stunned to learn that taxes could take more than half of their financial windfall. Recipients of startup stock can give themselves more choices to reduce their tax liabilities by learning and planning, even before the equity is granted.

It's important to understand several key differences between the types of equity and how they are taxed upon grant, upon vesting, upon conversation to stock (if applicable), and upon sale. Many other firms have written about the importance of making an 83(b) election, including Abacus Wealth, Brighton Jones, and Kruze Consulting, so I won’t repeat those details here.

If you are a contractor or advisor, you may prefer to receive restricted stock instead of non-qualified stock options. Or, depending on your risk tolerance, ownership goals, and cash flow expectations, you may prefer to receive warrants instead.

Note: this article covers intermediate and advanced-level concepts, particularly around taxation. It is meant to provide general information only – many low-level details are beyond the scope of this article. Readers should consult a qualified tax professional who knows your specific situation before making any decisions.

Understand the Two Types of Startup Stock Options

A startup stock option gives the recipient the choice in the future to buy company stock at a pre-determined exercise price. To avoid tax problems, the exercise price (a.k.a., “strike price”) on stock options should be the fair market value (FMV) of a share of common stock.

Note that stock options may go “under water”, which is a disheartening situation where the strike price is higher than the current FMV. This can happen if an employee is hired today and granted stock options with a $3.00 strike price, which is the current FMV of a share of common stock. Unfortunately, a year later, the company faces headwinds and underperforms and raises down round of funding, which is a funding round at a lower valuation than the previous round. The FMV of the common stock might drop to $1.00 per share. If so, the stock option this employee received is under water since the common stock’s current FMV is below the strike price.

There are two types of stock options: Incentive Stock Options and Non-qualified Stock Options. They differ in who can receive them and how they are taxed. Stock options are often used by early-stage and mid-stage startups to incentivize recipients.

Occasionally, the startup’s stock option plan that governs both types of stock options will give the recipient the choice to exercise the options early (before they are fully vested). Exercising your options early have a number of benefits and risks that are well documented by a number of financial advisors, including Anisha Sekar, Kristin McKenna, and Mary Russell.

Incentive Stock Options (ISOs)

ISOs can only be granted to employees of the startup. Under certain conditions, ISOs may qualify for preferential tax treatment. ISOs are the most common form of equity incentive for startup employees. When speaking about startup stock options, people are usually referring to ISOs.

Non-qualified Stock Options (NSOs)

NSOs aren’t as restrictive as ISOs, as they can be granted to both employees and non-employees. Unfortunately, they lose some of the preferential tax treatment available to ISOs.

Restricted Stock Awards (RSAs)

RSAs are a grant of the company’s common stock with certain important terms and conditions. The main restriction is typically a vesting schedule (or technically, a repurchase right that resembles a vesting schedule). Where stock options provide the recipient the right to buy shares at a fixed price, RSAs are actual grants of stock. The recipient of a stock option does not actually own any stock until they decide to exercise the option and pay the purchase price, while recipients of RSAs do own stock from the date the grant is accepted.

Restricted stock units (RSUs)

RSUs are rights to acquire shares of the company’s common stock subject to specific terms and conditions. RSUs can be thought of as a stock option without requiring the recipient to pay anything to own the stock.

If stock options are the most common way to incentivize workers and RSUs are very similar, why do RSUs exist? Well, when the startup is young, the company’s valuation is probably low, meaning the share price will be low. As the startup grows and matures, the valuation increases, meaning the price per share will also increase. If the valuation becomes large, then the FMV of a share of common stock will drive up the exercise price of the stock option – remember, the exercise price on stock options should be the FMV of a share of common stock at the time the option is granted. With a high exercise price, many employees who want to exercise the stock option and hold the stock will not be able to do so because they will likely struggle to find the funds to pay the exercise price for all the shares they want to buy. Because RSUs do not have an exercise price, no funds are required to purchase the stock once the RSUs vest. (The recipient will still likely have to pay withholding tax on the vested shares, but this tax burden is usually much smaller than the total cost to exercise the options.)

Because of this, RSUs are more popular with later-stage startups where the valuation has grown to the point that stock options are no longer as attractive. In addition, because there is no strike price, the RSUs will never be “under water”. Even if the company struggles and the value of the stock dramatically decreases, RSUs will still hold some value. Do note that, as startups transition from granting stock options to RSUs, they typically reduce the number of shares (or rights to shares) granted.

Warrants

Warrants are the right to purchase stock at a pre-determined price. Warrants are the least common of these five types of startup equity. Warrants are very similar to stock options but differ as indicated in the table below.

Note that the table above includes detail about dilution. A key concept with startup stock is “Fully Diluted Shares” which is the total number of shares in the company should all equity obligations need to be fulfilled. This non-trivial concept is important to determine every stakeholder’s percentage ownership stake in the company. For a visual explanation of fully diluted shares, watch our YouTube video here.

Tax Summary

Taxation of startup equity is highly complex. Since we are not tax advisors, our focus in creating this blog is purely educational and informational. The table below summarizes resources created by professional tax advisors and is provided as a convenience only. Interested readers can refer to the resources at the end of this blog, or contact their own qualified tax professional.

The blue text in the table captures a few highlights on:

83(b) election: whether an 83(b) election is possible and when it is typically done by the recipient.
Recipient’s tax impact upon grant: the typical tax situation when the recipient receives the equity instrument.
Recipient’s tax impact upon vesting: the typical tax treatment when your equity rights are no longer subject to time-based or milestone-based goals.
Recipient’s tax impact upon conversion to stock: the typical tax impact when your equity rights convert to actual stock in the company.
Recipient’s tax impact upon sale: the typical tax situation when you sell or otherwise dispose of the stock or stock rights. Note that gain is defined as funds received from the sale of the instrument minus the acquisition (or basis) cost of acquiring the instrument.

Educated Founders Make Better Decisions

If you’ve made it this far through this article, I applaud you! Most founders don’t spend the time learning about the details of their work and end up victimized two to five years down the road by a poor decision or a missed opportunity in the past.

If you've been offered equity in a startup and want to analyze how much it might be worth as your equity vests over time, take a look at our Startup Stock Vesting Calculator.

As Simon Sinek (one of my favorite speakers) says in this YouTube short, you chop more wood if you sharpen your axe. Entrepreneurs running a startup have a lot of wood that must be chopped. Make sure you take the time continue to sharpen your entrepreneurial axe. And if you need a sharpening stone, take a look at our detailed startup training content. We’ve walked the startup journey many times (five startups with three exits). We’ve built a ton of startup content that we wish we had when we were building our ventures. We hope our training and resources helps you build your own fundable startup!