Equity Compensation: Restricted Stock vs. Stock Options
At Eight One Partners, we often encounter business owners and advisors grappling with the complexities of equity compensation. Whether you're an advisor looking to secure equity in a startup or a founder figuring out the best way to reward your team, understanding the nuances of restricted stock and stock options is critical. This post will dive into a recent discussion with a client who faced these decisions, providing insight into how to approach equity compensation strategically.
The Scenario: Stock Options vs. Restricted Stock
A client, who is an advisor to a startup, recently sought advice on whether to accept nonqualified stock options or restricted stock as part of their compensation. The first rule of thumb in these scenarios is to understand the implications of each option from both a tax and ownership perspective.
1. Be Wary of Cashless Compensation
If you're an advisor and are offered equity instead of cash, be cautious. While equity can be incredibly valuable, it's essential to recognize that the founder might see this as granting you significant value and thus a partnership in the business. However, this can create an imbalance in expectations. You might not see the immediate value, especially if the equity doesn’t translate into liquid assets anytime soon.
2. The Benefits of Restricted Stock
For early-stage companies, restricted stock can be advantageous. If the company is in its infancy and the common stock is valued at pennies, securing a restricted stock grant allows you to lock in your capital gains early. Holding this stock for over a year, especially within a C corporation, could provide significant tax benefits, potentially reducing the tax burden when you eventually sell.
Restricted stock grants become particularly attractive if you believe in the company’s long-term potential. Since the value of the stock is low at the time of the grant, the tax impact might be minimal. However, one critical action to take when receiving restricted stock is to make an 83(b) election. This election allows you to pay taxes on the stock at its current value rather than at the potentially much higher value when it vests. Failure to make this election within 30 days can lead to a significantly higher tax bill later on.
3. The Case for Stock Options
Stock options are another route, especially if the current valuation of the company is high. If you receive a stock grant at a high valuation, the tax burden can be substantial because you’ll owe taxes on the fair market value of the stock at the time of the grant. A grant of shares that results in a $30,000 tax bill might be unaffordable, especially if the company’s future is uncertain.
Stock options offer a way around this. While they may not be ideal from a tax perspective—since gains are often cashed out and taxed as ordinary income—they do allow you to delay the tax burden depending upon the tax attributes of the options. This can be particularly useful if you’re not in a position to pay taxes on a high valuation upfront.
4. The Dangers of Ignoring the 83(b) Election
One cautionary tale involves an individual who ignored the 83(b) election, confident that it wasn’t necessary. Unfortunately, when the restricted stock vested, the company’s value had skyrocketed, leading to a massive tax liability that could have been avoided. The result? The individual had to forfeit their shares to avoid the tax burden.
This situation underscores the importance of working closely with a tax advisor and ensuring that all paperwork, including the 83(b) election, is filed correctly and on time. Missing this critical step can have long-term financial consequences.
Key Considerations When Accepting Equity
When considering equity compensation, it’s essential to evaluate the company’s stage, your financial situation, and your long-term goals. Here are a few questions to ask yourself:
Can you afford the potential tax burden? If not, stock options might be the safer choice.
Do you believe in the company’s long-term potential? If you’re confident in the company’s future, restricted stock with an 83(b) election could maximize your gains.
Are you prepared for a long-term relationship with the founder? Equity compensation often ties you to the company for several years. Ensure you’re comfortable with the team and the company’s direction.
Is the founder someone you can work with over the long haul? A good relationship with the founder is crucial. If you foresee difficulties, it might be best to avoid equity compensation altogether.
In one case, an individual who held shares since 2016 recently received an offer to move those shares into a new company after the original company was closed down. This scenario illustrates the long-term nature of equity compensation—it’s not just about the immediate value but also about the ongoing relationship with the company and its management.
Conclusion
Equity compensation is a powerful tool for aligning interests between advisors, employees, and founders. However, it requires careful consideration and planning. At Eight One Partners, we advise our clients to approach equity compensation with caution, ensuring that all tax implications are fully understood and that the relationship between the parties is solid. Always consult with your tax advisor and legal counsel before accepting equity, and make sure that you’re making the right decision for your financial future.
By understanding the nuances of stock options versus restricted stock, you can make informed decisions that will benefit you in the long run.
If you have any questions about equity compensation or need guidance on your specific situation, reach out to us at Eight One Partners. We're here to help you navigate these complex decisions with confidence.
