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In preventing and managing startup disputes, I’ve encountered some confusion among founders regarding unvested shares, specifically how and when to repurchase them. The answer is somewhat complex, so let’s start with the basics.
Stock vs. stock options
Oftentimes when early-stage founders (particularly first-time founders) think about equity, they think of granting stock options. This is not surprising. For many in the startup world, their only real experience getting equity is receiving stock options as an employee of a larger company. The reality is that most early-stage startups should be granting stock, and not stock options.
What’s the difference?
A stock option isn’t stock at all. It’s a right to purchase stock at a predetermined price (the “exercise price” or “strike price”). That price should be the fair market value of the stock on the date of grant.
Stock options are subject to regulations under Section 409A of the Internal Revenue Code. Those regulations are complicated and, if not followed, can lead to significant penalties. Failure to comply with Section 409A can pose diligence problems as well. The last thing you want to see is an investor or acquirer insisting that you cancel option grants due to non-compliance with Section 409A.
At formation and in the months that follow (assuming the company hasn’t gained measurable value), the value of a share of the company’s stock is likely near zero. Rather than incurring the expense and hassle of issuing stock options, you can simply grant stock.
When you grant stock, the employee or other service provider has to either pay the fair market value of the stock or that value is treated as taxable income. But given that the share price would be low at the earliest stages, this doesn’t present a financial burden
You may wonder why you should ever issue options. Down the line, when your share price is non-trivial, it may be too expensive to issue shares to employees. Either the employee won’t want to go out of pocket that much, or, if the company wants to do an outright grant without payment, the tax hit would be too high.
Vesting of stock vs. vesting of options
When you are granting equity to employees and other service providers, one of the first thoughts is vesting arrangements. Vesting works differently when dealing with either stock or options.
For options, the concept is very simple. Given that options are a right-to-purchase stock, an employee has the right to purchase a specific number of shares when that option vests. If the option ceases to vest, the employee loses the right to exercise the option with respect to the unvested portion.
For stock, the vesting works quite differently. In an ideal scenario, when you issue stock subject to vesting, you issue all of the shares on day one. The company, however, retains a right to repurchase any unvested shares at the original issued price (perhaps $0.00001 per share). As the shares vest, the company’s right to repurchase vested shares lapses.
This means that, in situations where an employee only gets shares as they vest, that person will pay (or be taxed on) the fair market value (FMV) of shares upon each subsequent vesting date.
As the FMV goes up, that value will go up. And suddenly each vesting date will result in either a big tax hit or a big out-of-pocket expenditure for the shares that vest.
By issuing the shares outright, subject to the company’s right of repurchase, an employee can lock in a low FMV on the date of grant with respect to all shares — so long as the employee files a timely 83(b) election with the IRS. If, as a founder, you’re interested in repurchasing unvested shares down the line, keep in mind that this only applies if you issue stock rather than options.
How do you choose which to grant? It really depends on each company’s unique position. As mentioned, granting stocks is a straightforward approach and puts less of a financial burden on the company. But granting options can prevent issues down the line should your shares become too expensive to issue to employees. It’s a question of what your company is capable of doing now versus what could happen down the road.
The information contained in this article is provided for informational purposes only, and should not be construed as legal advice on any subject matter. You should not act or refrain from acting on the basis of any content included in this article without seeking legal or other professional advice.