1. What every Startup should know about Paying with Equity
LINDA KNOBBE, TAX PARTNER
October 17, 2016

2. PAYING WITH EQUITY Pros
Doesn’t use up company cash to pay
salaries
Can encourage loyalty
Gives recipients a potential share in future success
Cons
Can be costly to set up and manage
Reduces founders’ share of equity
Complex to value
By Mukund Mohan bestengagingcommunities.com/2012/07/29/should-i-pay-my-lawyer-or-advisor-in-stock/

3. EXAMPLES OF EQUITY COMPENSATION SUCCESS
Jeremy Stoppelman Yelp
Cash Compensation: $340,657
Yelp holdings worth $250.6 million
Joe Mansueto Morningstar
Cash Compensation: $105,295
Morningstar holdings worth $1.9 billion
Kosta Kartsotis
Fossil Group
Cash Compensation: $0
Fossil holdings worth $716 million

4. RESTRICTED STOCK
Grant of company stock that may be subject to forfeiture if certain future conditions are not met
Equity ownership granted without a purchase price paid by employee.
The simplest way to grant equity ownership in exchange for services
No income or tax until vested. Taxable as ordinary income upon completion of vesting schedule. Then capital gain tax applies upon sale of stock.
May qualify for 83b election and allow recipient to "prepay" taxes based on stock value at grant date. This election reduces overall taxes if stock appreciates between grant date and vested date.
Tax deduction for company when restrictions met, or at date of 83b election.
Immediate ownership, but subject to later forfeiture (typically time or performance-based)
Complex issues regarding determination of grant date, vesting date and valuation
Compensation value is Intrinsic value (difference between FMV and strike price).

5. PHANTOM STOCK OR STOCK APPRECIATION RIGHTS
Contractual bonus tied to company stock value or appreciation of its value
Can be settled in cash or stock
Taxable as ordinary income on amount of bonus
Tax deduction upon bonus paid
Does not give away company equity, unless settled in stock
Possible ERISA (Employee Retirement Income Security Act) issues if it resembles a qualified plan (ESOPs or 401(k)). If the plan is designed for a limited number of employees, or as a bonus for a broader group of employees that pays out annually based on a measure of equity, would most likely avoid these problems.
Valuation can be complex.

6. INCENTIVE STOCK OPTION (ISO)
Option to purchase company stock
Preferential tax treatment
Limits on use, must be designed within ISO rules to qualify
Pays only if stock price increases
Taxable at Capital Gains rate when stock is sold. Ordinary taxable income if stock not held for 1 year after exercise and for at least 2 years after the grant of the option
Possible AMT consequences
No tax deduction unless employee disposes of stock prior to meeting holding requirements
Ownership is effective when option exercised.
Limits on Exercise Price, Value of Grant, Term of Grant and Term of Plan
Complex plan documentation
Complex valuation and amortization

7. ISO Qualifications
Must be granted to an employee (not advisors, contractors, etc.)
Exercise price must be must be at least equal to grant date Fair Market Value
Cannot be transferred-except on death
Must be granted pursuant to a plan approved by board of directors
Must be granted within 10 years of plan approval
Must be exercised within 10 years of grant and within 3 months of a termination from service
Aggregate Fair Market Value of all ISOs exercisable during any calendar year may not exceed $100,000.
If these are not met, the option is treated as an NQSO
Note: additional rules if granted to a 10% or greater shareholder.

8. NONQUALIFIED STOCK OPTION (NQSO)
Option to purchase company stock
Corporate tax deduction when exercised
Taxable as ordinary income on exercise (for spread between strike and FMV of shares); Then, capital gain tax on growth after the exercise.
Tax deduction upon exercise when option exercised
Possible 409A considerations, if exercise price is less than FMV
Complex plan documentation
Complex valuation and amortization for GAAP purposes

9. PARTNERSHIP PROFITS INTEREST
Holders of Profits Interest granted share of increase in value of company over stated period of time Shares in profits only, not an equity stake.
Can only be utilized for LLCs or partnerships
May need valuation to determine company value
Taxable at Capital Gains rate when disposed (exit or sale)
No taxation at grant if "safe harbor" met
Allocated profits from partnership are taxable when reported on Schedule K-1.
No tax deduction
Immediate ownership, but only to the extent of increased value after grant Annual capital account maintenance required. Multiple valuation dates creates additional complexity.
Maintenance of capital table and accumulated earnings/profits
Grant to an employee makes them a partner.

10. 409A Implications for Startups
409A Qualified Arrangements
A legally binding obligation that the company owes the employee (via contract or other legal right)
Plan must be in writing
The deferral election must be made in advance of the year in which the compensation is earned
The time and form of payment must be determined up front and cannot change (so the company needs to set the dates these deferred payments will occur, it can’t just be “when cash is available”)
Accelerated payments cannot be made (only upon death, disability, or separation from service)
The Internal Revenue Service created Section 409A to address deferred compensation. It applies, generally, anytime compensation is earned in one year, but not paid until a later year.
If the 409A rules are not met, then the compensation is taxed when earned, not when paid.

11. FINAL THOUGHTS
Pay careful attention to your cap table and keep it updated at all times.
Monitor fully diluted ownership.
Check in with your tax advisor frequently to stay on top of tax consequences.
Check in with your legal advisor to make sure you don’t grant what you haven’t authorized.

12. THANK YOU! QUESTIONS? LINDA KNOBBE, CPA Tax Partner
Member of BDO’s Technology & Life Sciences Practice
Direct: