Startups represented by seedling growthStartup clients often rely on independent contractors and advisors during their early stages but do not have the cash to pay them, so they turn to equity compensation. Stock options are a great incentive tool, but founders should consider the following before issuing options to advisors or independent contractors:

  1. How Much?: Most founders grant early advisors and contractors options that cover anywhere from 0.10% to 1% of the company’s fully diluted stock on a case-by-case basis. Founders should consider (i) how important the advisor or contractor is to the success of the company, (ii) how much time the advisor will commit to the company, and (iii) the maturity level of the company and its future growth prospects. Advisors and contractors may talk to one another about their option grants, so be consistent and prepared to explain the rationale behind the grants.
  2. Vesting: Just like option grants to employees, advisor grants should be subject to a vesting schedule. Advisor grants typically vest on a monthly basis without a cliff over a period of 12-24 months, although shorter or longer vesting schedules may be appropriate. In certain scenarios, vesting schedules for independent contractors may be customized so that all or a significant portion of the grants do not vest until completion of the project for which the contractor was hired.
  3. Exercise Period: Vested Incentive Stock Options (ISOs), which can only be granted to employees, must be exercised within three (3) months after the employee’s termination. This is not the case for Non-Qualified Stock Options (NSOs) issued to contractors and advisors, but most equity incentive plans require both types of options to be exercised within the three (3) month period. Experienced advisors may negotiate to extend the exercise period because they do not have the cash to exercise the options or are not prepared to pay the tax associated with exercising the options. Depending on the relationship with the advisor, it may be in the company’s best interests to extend the exercise period, especially with advisors who may be able to help the company in the future through their expertise or connections.
  4. Intellectual Property: All advisors should sign some form of confidentiality and invention assignment agreement. Although many advisors or contractors may resist, such agreements can be tailored to address the advisor’s concerns while still protecting the company ownership of its intellectual property, which is key to the company’s future success and ability to obtain venture financing.

Ethan Zook and Jacob Oksman write:

Attracting and retaining high-performing employees is critical to the success of any emerging company. A key ingredient to securing the right talent base is an attractive and aligned remuneration plan. Most emerging companies will structure their remuneration plan leveraging three key elements: a competitive base salary, a short-term bonus plan, and a long-term incentive plan (LTI) that typically comes in the form of a stock option plan. The base salary and bonus plan are typically structured to align the individual and the company against critical objectives, and normally present in the form of cash compensation. The LTI plan, on the other hand, is structured with a longer-term horizon in mind, and is intended to align the company, employees, and shareholders for long-term value creation.

Business Taxation
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While an integral way for emerging companies to attract top talent, employees need to understand the type of LTI vehicle used, and tax implications from a vesting, exercising and selling perspective.

In general, there are two basic kinds of stock options: statutory stock options and nonstatutory stock options (NSOs). Both generally allow the recipient to buy stock at a fixed price for a defined number of years into the future. By doing so, the option holder takes part in the overall value creation of the company. The award will typically vest over a pre-determined period of time, or upon certain milestone achievements. Once shares are vested, the holder has the option of selling the earned shares. There are, however, significant differences between the two types of awards from a tax perspective.

Statutory stock options include incentive stock options (ISOs) and options granted under employee stock purchase plans. Upon grant and exercise of ISOs, there are generally no tax consequences to the employee. However, the employee may be subject to alternative minimum tax in the year of exercise. Upon sale of the stock received by exercising the ISOs, the employee will generally have capital gain or loss if the stock acquired on exercise is held for at least two years from the date of grant and one year after the ISOs were exercised.

NSOs are not taxed to the employee receiving them when granted unless the options have a readily ascertainable fair market value at that time (this generally includes marketable securities). If the options do not have a readily ascertainable fair market value when granted, the employee is taxed on the gain from the options at the time of exercise or transfer (even if the fair market value becomes readily ascertainable before the exercise or transfer). Unlike statutory stock options, upon exercise of NSOs, an employee will have compensation income (taxed as ordinary income) equal to the difference between the fair market value of the stock at the time of exercise and the price paid for the stock (if any). If the options are sold, then the employee will have compensation income equal to the gain on disposition. The sale of the stock received by exercising NSOs will generally result in capital gain or loss (and are not subject to the special holding period requirement discussed above for ISOs).

ISOs are generally considered more tax friendly than NSOs, but both employees and employers need to be aware of the tax scheme.

Navigating the tax treatment of options can get complex quickly; it would be wise to reach out to a tax professional before making the ultimate decision of receiving or exercising equity compensation.


Ethan Zook is an associate in the firm’s Corporate Department, resident in its Exton, PA office.

Jacob M. Oksman is an associate in the firm’s Taxation & Wealth Planning Department, resident in its New York office.

A recently passed House bill would permit certain start-up employees to defer taxes on stock options and restricted stock units (RSUs).  The proposed legislation aims to help emerging companies attract and retain talent by offering equity compensation on more attractive terms.

Business Taxation
Copyright: yupiramos / 123RF Stock Photo

Cash-strapped start-ups often grant an ownership stake to employees to compensate for below-market wages.  This strategy also aligns incentives by giving employees a share of the company’s growth.

However, current tax law makes such equity compensation less attractive than it might otherwise be.  When employees exercise their stock options or when RSUs vest, they must pay taxes on the excess difference between the current fair market value and the purchase price.  Of course, the employee hasn’t actually pocketed any cash.  So the income is “phantom” income, but the tax burden is real.  Public company employees have the option to sell shares on the open market, but there is typically no market for private company stock.  Employees must choose between paying taxes out of pocket or foregoing their ownership stake.  This Hobson’s choice can dilute the value of equity compensation, making it more difficult for emerging companies to attract top talent.

The Empowering Employees through Stock Ownership Act (the “Act”) seeks to alleviate this tax burden on illiquid income.  Qualified employees working at eligible companies could defer paying taxes on income from qualified stock for up to 7 years.  Let’s unpack those terms:

  • Qualified Employee:  To take advantage of the tax deferral, employees must be “qualified employees”.  This includes all employees except certain owners and officers:  owners of 1-percent or more of the company, certain executives (CEO, COO or individuals acting in such capacity), and the company’s four highest earning officers are excluded.
  • Eligible Companies:  The Act is intended to incentivize broad-based employee ownership.  If a company wants its employees to qualify, it must have a written plan under which at least 80% of all U.S. employees who provide services to the company are granted stock options or RSUs on an annual basis.  The company must also offer stock options or RSUs to employees on similar terms.  Finally, the company cannot be traded on an established market.
  • Qualified Stock:  Qualified stock includes stock received in connection with the exercise of a stock option or vesting of a RSU.  The stock must be received as compensation for services performed as an employee of the company.  Importantly, stock is not qualified if the employee has the right to sell the stock to the company at the time of exercise or vesting or to otherwise receive cash in lieu of the stock.
  • 7-Year Deferral:  Employees are currently required to pay taxes in the year in which they exercise stock options or their RSUs vest.  Under the Act, employees would not have to recognize (or pay taxes on) this income until 7 years after exercise or vesting.  Certain triggering events could cause employees to have to pay taxes prior to the 7-year anniversary:  if the stock becomes transferable (including to the employer), if the employee becomes an excluded employee, if the stock becomes tradeable on an established market, or if the employee revokes the election.

Despite some controversy over how this tax deferral will be paid for, the Act is generally receiving praise as a move to strengthen the economy and create jobs by helping early stage companies attract the talent that will help them succeed.