August 21, 2021 5 minutes read
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I've seen founders confused about unvested shares and how to repurchase them. This is because I have been involved in the prevention and management of startup disputes. It is not an easy question to answer, so let's start with the basics.
Stock vs. stock option
Many times, early-stage founders, especially first-time founders, think about equity when they think of stock options. It is not surprising. Many people in the startup industry have never had any experience with equity. They only know how to get stock options from larger companies. Realistically, most startups in the early stages should grant stock and not stock options.
What is the difference?
Stock options are not stock. It is a right to purchase stock at a specified price (the exercise or strike price). This price should reflect the fair market value at the date of grant.
Section 409A (Internal Revenue Code) regulates stock options. These regulations can be complex and can result in severe penalties if they are not followed. Failure to comply with Section 409A could also cause diligence problems. You don't want an acquirer or investor insisting on cancellation of option grants because you have not met Section 409A.
Related: Could Walmart be the ultimate growth stock?
Stock grant
If the company doesn't have measurable growth, the stock value is likely to be near zero at formation and throughout the years. Instead of wasting time and money issuing stock options, grant stock instead.
Stock grants require that the employee or service provider pay the fair market price of the stock. If the stock is deemed taxable income, it must be paid. This doesn't create a financial burden, as the share price is low in the initial stages.
It is possible to wonder why options should be issued. If your share price is not trivial, it might be too costly to issue shares to employees. Either the employee will not want to pay taxes or the company won't be able to give out shares without paying any tax.
Related: Three Key Points Companies Should Consider about Stock Options Right Now
Stock vesting vs. options vesting
Vesting arrangements are an option when you grant equity to employees or other service providers. You can use options or stock to vest your stock differently.
The concept of options is simple. Options are a right to buy stock. Employees have the right to purchase a certain number of shares once an option vests. The employee can no longer exercise the option if the option is vested.
Vesting for stock works in a different way. If you issue stock subject vesting, all shares are issued on the first day. However, the company retains the right to repurchase unvested shares at their original issue price (perhaps $0.00001 each share). The company's right to repurchase shares that have already been vested lapses as the shares become fully vestable.
In other words, if an employee gets shares only as they vest, the person will pay or be taxed on the fair market value of the shares at each subsequent vesting date.
This value will increase as the FMV rises. Each vesting date will have a significant tax impact or an out-of-pocket expense for the shares.
Employees can get shares in full, subject to the companys right to repurchase. This allows them to lock in a low FMV at the date of grant for all shares, provided they file a timely 83 (b) election with IRS. If you are a founder and would like to repurchase unvested shares later on, this is only possible if the employee files an timely 83(b) election with the IRS.
How do you decide which grant to give? It all depends on the company's particular situation. It is easy to grant stock options and places less financial burden on the company, as it is straightforward. However, granting options can help to prevent future issues if your shares become too costly to issue to employees. It is a matter of what your company can do now and what you might be able to do in the future.
This article contains information that is intended to be used as information only and not meant to be considered legal advice. Without seeking professional or legal advice, you should not act on or refrain from acting based on any information contained in this article.
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