You want to reward and incentivize your CFO and CMO with equity in the company. What’s the best approach?
First, make sure equity provides the right incentives. For the CFO almost certainly, because the CFO shares responsibility for the profitability of the whole company. For the CMO, maybe not. If we want the CMO focused on sales, maybe a cash commission makes more sense. On the other hand, you might decide that owning stock will have a positive psychological effect for your CMO, even if it doesn’t offer a direct incentive.
With that box checked, these are the most common equity-flavored alternatives:
- Restricted Stock: The CFO might receive a total of 100 shares of stock today, with her right to receive distributions and otherwise enjoy the full benefits of the stock subject to a vesting schedule. The vesting schedule might be based on time (g., 20 shares per year for five years), economic milestones (e.g., 20 shares for each year showing a growth of at least 20% in cash flow or EBITDA), or a combination of the two.
- Stock Options: The CFO might be granted the option to purchase 100 shares of stock for $0.10 per share (hoping they will someday be worth a lot more), subject to the same vesting schedule. Under section 409A of the tax code, that $0.10 per share exercise price must be the true fair market value at the date of grant, not an artificially low number.
- Incentive Stock Options: If the company is a corporation (not an LLC) and satisfies lots of special rules, the CFO might be granted a special kind of stock option, with special tax benefits.
- Phantom Stock: Rather than actual stock, the CFO might receive a contract right intended to achieve the same economic result.
In the world of entrepreneurs generally and the Fintech and Crowdfunding worlds specifically, restricted stock and stock options are the most common choices, so I’m going to focus on those today.
Economically, restricted stock and stock options are almost identical. But the tax consequences can be quite different. For purposes of the discussion below, I’m assuming (i) the CFO’s 100 shares are worth $0.10 per share today and increase in value at the rate of $1.00 per share per year, (ii) the CFO is given 10 years in which to exercise the options, and (iii) the company is sold in 10 years.
Scenario #1: Direct Stock Issuance – General Rule
If the CFO receives 100 shares today, vesting over five years, then she has zero taxable income today because no shares have vested. At the end of the first year she has $22 of taxable income (20 shares vested @$1.10 value per share), at the end of the second year he has $42 of taxable income (20 additional shares vested @$2.10 value per share), and so on. The employee must pay tax on this income each year, while the company can claim a corresponding tax deduction. Thus, over the duration of the vesting period the CFO pays tax on $310 of taxable income and the company obtains a $310 tax deduction.
In this example the CFO will pay roughly $100 of tax on his $310 of taxable income (depending on tax bracket, state of residence, etc.). The exact amount of the tax isn’t important. What’s important is that (i) she will have to fund this cost from her own pocket, and (ii) if the company is very valuable or she owns a lot of stock, her out-of-pocket tax cost could be prohibitively high.
When the company is sold after 10 years, the CFO will receive $1,010 for her shares and have $700 of gain. This $700 would be taxed at long term capital gain rates, and at that point she’ll have the cash to pay her tax.
Scenario #2: Direct Stock Issuance Followed by §83(b) Election
Where an employee receives stock subject to a vesting schedule, §83(b) of the tax code permits an employee to elect to report as taxable income the entire current value of the stock. Having made the election, the employee does not report any additional taxable income as the stock vests.
In our example, the CFO could make an election and report $10 of taxable income on the date of grant (100 shares of the @ $0.10 per share). She would then have no additional taxable income as the stock vests, and the company would have no tax deductions. Upon the sale of her stock the employee would have $1,000 of income, taxed at long term capital gain rates.
An election under §83(b) must be filed with the Internal Revenue Service within 30 days after the CFO receives the stock.
NOTE: Suppose the company fails after two years. Now the CFO has paid tax on $10 and has nothing to show for it except a $10 capital loss. That’s the downside of section 83(b).
Scenario #3: Options
The CFO recognizes no current taxable income as a result of receiving options. Instead, she recognizes taxable income as the options are exercised, equal to the difference between the exercise price of $0.10 per share and the value of the stock at the time.
In the simplest scenario, where the CFO exercises options to purchase 20 shares each year, the tax effect would be almost identical to Scenario #1 above. The CFRO would recognize $20 of taxable income in the first year, $40 the next year, and so forth, for a total of $300 of taxable income. No §83(b) election is available with options.
A more likely scenario is that the CFO wouldn’t (or wouldn’t be allowed to) exercise the options each year, but rather waits to exercise until the company is sold. In this case she would recognize no taxable income until sale, and at that point would recognize $1,000 of taxable income, taxed at ordinary income rates rather than capital gain rates. The company would be entitled to a corresponding deduction of $1,000. Again, the CFO would have plenty of money to pay the tax.
Options are simpler than restricted stock, especially if they can’t be exercised until an exit. And the holder of an option, unlike the holder of actual stock, has no right to see confidential information that the company would prefer to keep private.
For that reason, options typically make more sense from the company’s viewpoint, even though the employee might end up paying more tax (ordinary income vs. capital gains) overall. But every company and every situation is different.
Questions? Let me know.