Early-stage startups often struggle to offer competitive salaries to their team members due to financial constraints.
What You Need to Know: Start up owners often rely on equity incentives to supplement lower cash compensation. While there’s ample information available on stock options for employees, less attention is given to equity options for non-employees.
This following is a brief overview of 5 common types of startup equity compensation:
- Incentive Stock Options
- Non-qualified Stock Options
- Restricted Stock Awards
- Restricted Stock Units
- Warrants
Understanding these equity options is crucial for founders, employees, and contractors alike. 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.
Two Types of Startup Stock Options
What You Need to Know: Two categories of stock options exist:
- Incentive Stock Options
- Non-qualified Stock Options
They vary in eligibility criteria and tax treatment. These options are commonly employed by early-stage and mid-stage startups to motivate their recipients.
Digging Deeper: A startup stock option offers the recipient the opportunity to purchase company stock at a predetermined price in the future. To prevent tax complications, this price, also known as the “strike price,” should match the fair market value (FMV) of a share of common stock.
It’s important to note that stock options can sometimes become “underwater,” a situation where the strike price exceeds the current FMV.
For instance, if an employee is hired today and granted stock options with a $3.00 strike price, reflecting the current FMV, but a year later, the company faces challenges, resulting in a down round of funding at a lower valuation. Consequently, the FMV of the common stock might drop to $1.00 per share, rendering the employee’s stock options underwater, as the current FMV falls below the strike price.
5 Choices
1. Incentive Stock Options (ISOs):
ISOs are exclusively available to employees of the startup. Meeting specific criteria may render ISOs eligible for preferential tax treatment. Among equity incentives for startup employees, ISOs are the most prevalent. When discussing startup stock options, ISOs are typically the focus.
2. Non-qualified Stock Options (NSOs)
NSOs are less restrictive compared to ISOs, as they can be granted to both employees and non-employees. However, they forfeit some of the favorable tax treatment afforded to ISOs.
3. Restricted Stock Awards (RSAs)
RSAs entail a grant of the company’s common stock with stipulated terms and conditions. Typically, a primary restriction is a vesting schedule (or technically, a repurchase right resembling a vesting schedule). While stock options grant the right to purchase shares at a fixed price, RSAs involve actual stock grants. Recipients of stock options don’t possess any stock until exercising the option and paying the purchase price, whereas RSA recipients own stock from the grant acceptance date.
4. Restricted Stock Units (RSUs)
RSUs represent entitlements to acquire shares of the company’s common stock under specific terms and conditions. RSUs can be likened to stock options without necessitating any payment from the recipient to own the stock.
5. Warrants
Warrants grant the holder the right to buy stock at a predetermined price. Among these five types of startup equity, warrants are the least prevalent.
