1. Dividing shares among employees?

  • Create ESOP (Equity Stock Ownership Plan) – it is usually between 10 % – 20% and allows employees to own stock in the company without having to purchase shares.
  • Employee Stock Purchase (Option) Plan (ESPP) – allows employees to use after-tax wages to purchase stock in their companies, usually at a discounted price. Employees purchase stock with their own after-tax dollars and must pay capital-gains taxes when they sell their shares.
Whether you should start ESOP or ESPP, it all depends on your management approach and philosophy.

2. Hiring key employees

Set aside an option pool for future hires (unissued options). These shares are treated as reserved (these are not issued, they are just pull out from the authorized share) because there is a real intent to issue them. You reserve shares for ESO by creating a class and reserving shares.

3. 409a valuation & other tax implications

409A valuation is utilized to find the fair market value (FMV) of a business which is usually set up by a third party valuation services.

Why is FMV required and what is 409a valuation?

409a is an appraisal of the Fair Market Value (FMV) of your start-up company’s common stock. You need to know current value of your common stock as the IRS would like you to get an appraisal once you start granting stocks to your employees.

When do I need a 409A? How frequently does a 409A valuation need to be performed?

409A expires after 12 months or after an event which materially affects the value of your company. However, an expired 409A doesn’t mean you have to race out and get another one. You can keep going with business as usual until you decide you want to issue more options. Then you must get a new one. Here are some of the reasons why you will need a new 409A valuation:

  • Once the last valuation is older than 12 months
  • Before merger, acquisition or an IPO
  • Before you issue your first common stock options (to your employees or advisors)
  • Every time you raise a new round of financing from any investor
  • When you have raised more than $500k
  • When you have preferred or convertible securities
  • When the company has more than $100k in assets

Once your 409A valuation is complete, the next step is to issue options.

Here are the tax and accounting actions that require correct FMV

  • Form 3921 – for option holders
  • ASC718 – Stock option expensing reports  
  • ASC505 – Stock option expensing reports for non-employees
  • 83(b) election letters – for early exercise option grants
  • AMT Tax
  • NSO tax withholdings – for employees
  • ISO $100k limits
  • Rule 701
  • Rule 144

4. Creating a vesting schedule

What does“4 year vesting schedule with a 1 year cliff” mean?

A vesting schedule allows employees to exercise their stock options. The usual set up is “4 year vesting schedule with a 1 year cliff”. Which means that the first year will be granted zero shares. An employee will be able to exercise the stock options once a year for the next 4 years. Stocks will be granted during these 4 years. The vesting might happen each month or each quarter. In other words, a typical options vesting package spans four years with a one year cliff. A one year cliff means that you will not get any shares vested until the first anniversary of your starting date. At the one year anniversary, you will have 25% of your shares vested. After that, vesting occurs monthly or quarterly.

5. Employees Stocks Options Plan (ESOP)

Investors shouldn’t determine (they usually do if they don’t see that you have already done this) the size of the option pool for you and your company. After formation, the founding team can split these shares amongst themselves, but should be sure to leave enough unissued for later. It’s common to keep the pool somewhere between 10-15% of the fully diluted shares. So before you accept any investment make your own decisions on how much equity you want to reserve for ESO equity class.

6. Choosing between stock options

  • NSO (Nonqualified Stock Options) – It can be granted anybody, employees or non-employees. There is however sensitivity in valuing the shares simply put, you must always come up with a fair market value (FMV). If you come up with lower value than FMV, the difference is regarded as capital gain and is taxed differently. This compensation is recorded as it vests.
  • ISO (Incentive Stock Options) – It can be granted to employees only. An employee can only vest $100,000 worth of ISOs in a given calendar year.  The strike price must be at a minimum equal to the FMV. If the employee holds the asset for more than 2 years, it is regarded as capital gain. Before you implement any of these, you should discuss it with your accountant.

7. Vesting schedule

When employees can exercise shares in specific time.

  • Year Cliff – A typical option vesting package spans four years with a one year cliff. A one year cliff means that you will not get any shares vested until the first anniversary of your start date. At the one year anniversary, you will have 25% of your shares vested. After that, vesting occurs monthly.
  • Incentive plan – This rewards employees for achieving certain milestones in the company. The milestone is usually the time – stay of the employee in the company. Stock-Based Incentive plan is the most common type of employee’s rewards.

8. Exercise price vs Market price vs Strike price

The strike price is the same as the exercise price. The price is known when the trade is taken. The value is created once the option is exercised – there is a difference between the fixed exercise price and the market price of the underlying option.

9. Expiration date

Expiration data is the last date you can exercise your options. Once any un-exercised options passes the expiration date then its value will be null.

10. Tax effects – you need to consider different tax effects

If employees exercised incentive stock options (ISOs) last tax year, your company must file Form 3921 with IRS. Companies must file one Form 3921 per employee, and if they miss the deadline or ignore IRS reminders and fail to file, they could end up paying expensive fines.

ASC 718 is the standard way company’s expense employee stock-based compensation on an income statement. Equity awards are part of compensation and have a specific set of accounting rules, stated in ASC 718, that companies should follow. Equity compensation ​is one of the most highly regulated activities.

ASC 505-50 rules require all firms to account for non-employee equity transactions based on either the fair value of the services received or the fair value of the equity instrument issued. ASC 718 provides guidelines on how to expense equity awards issued to employees.

To choose between ASC 718 – ASC 505-50 for both cases you will need to understand:

  • Forfeiture Rate – employees will leave and the stock comp expense is backed out.
  • Volatility – your own assumption
  • Peer’s – comparable public companies
  • FMV – Fair Market Value

83(b) election letters – letter employees send to the Internal Revenue Service letting them know they’d like to be taxed on their equity, such as shares of restricted stock, on the date the equity was granted to them rather than on the date the equity vests.

AMT Tax – calculates Alternative Minimum Tax (AMT) credit for Incentive Stock Option (ISO) exercise transactions and then utilize the credit to reduce future tax obligations. AMT top rate of 28% is lower than the regular tax top rate of 37%.

ISO $100k limits – not having to pay ordinary income tax on the spread between the fair market value (FMV) and the original exercise strike price when exercised. ISOs are still subject to Alternative Minimum Tax (AMT).

Rule 701 exempts certain sales of securities made to compensate employees and third parties such as consultants and advisors. It’s a federal exemption that allows private companies to issue up to $10M in equity to employees, without extensive disclosures. This must also meet a 12 month period.

Rule 144 stipulates certain conditions under which restricted, unregistered and control securities can be sold or resold. It is an exemption from registration requirements to sell the securities through public markets if a number of specific conditions are met.

4. Milestone: Create an Employee’s Stocks Options

1. Dividing shares among employees? Create ESOP (Equity Stock Ownership Plan) – it is usually between 10 % – 20% and allows employees to own stock in the company without having to purchase shares. Employee Stock Purchase (Option) Plan (ESPP) – allows employees to use after-tax wages to purchase stock in their companies, usually at … Continued

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