Getting Paid, Part I: Equity Compensation

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While our work can provide us with many benefits, at the end of the day our main goal is to earn income. What are you supposed to do, though, if a client offers you an alternative form of compensation other than cash? Many people have heard about the graffiti artist David Choe and how he took shares in Facebook for the art he provided at their office (it wound up being a great choice, as it was later valued in the hundreds of millions of dollars!). It’s not uncommon, particularly for cash-strapped start ups, to offer equity to workers. We’ll give you some tips about what to do if you find yourself in this situation.

Should You Take Equity?

Note, that we’ll use the words equity, shares, and stock somewhat interchangeably throughout this discussion. First off, we should discuss the risks and rewards of accepting equity as compensation. When David Choe accepted stock in Facebook as payment for his services, the company was likely a fledgling start up and not the behemoth tech company we know it as today. This will often be the case, as companies at this stage have less cash to spend and are more likely to seek out these alternative forms of payment. Developers are expensive, and if a company can get away with paying for a big project with their equity, it’s usually better for them at such an early stage when cash is in short supply. For the company, it serves three purposes: (i) they have less cash, so the more they can conserve the better; (ii) a company can issue shares fairly easily, and at a very early stage the stock isn’t valued as high (higher risk, higher reward as David Choe will tell you) because the prospects for the company are less certain as the business is usually in the “proof of concept” phase – so, if the business ends up failing the owners gave up worthless shares and not their cash; and (iii) paying a contractor/employee in shares also aligns everyone’s interest. If you’re paid in stock, you’ll be more invested in the project and will want to see it succeed so your stock is worth more!

With that being said, David Choe’s story is somewhat unique. Most people that are paid in equity don’t end up seeing a pay day of that magnitude. You should be cognizant of that when someone approaches you with this payment arrangement. A more stable, mature company will likely have the cash to pay you and will not opt for paying you in shares (and if they do, their stock could already be public, in which case it’s easy to value and sell the shares!). A new start up is going to be much higher risk, but with the potential for higher reward. These are the companies that venture capital firms invest in, and their strategy can generally be summarized as “we’ll have a lot of companies that fail and provide zero returns, but the few that are successful will make us so much money, it’ll end up netting out to positive returns.”

If you understand that, then you’re better equipped to structure your client engagements. If you work for every client for stock and no cash, you’ll find yourself in a tough spot when your rent payment is due. However, for some projects it may make sense to take the shares. Maybe it’s a project focused on a philanthropic cause you care about, or maybe it’s work for a friend and you don’t want to charge them too much. It could also be a company offering you 70% in cash and the remainder in stock, and you like the company’s product and think the shares would be a good investment. You’ll have to gauge how big the project is, how much time you’ll be spending on it (if it’s going to be 100% of your time for 3 months, you better have some savings if you’re only getting paid in stock!), and the prospect of the company succeeding. Typically, as a company becomes more mature, the stock becomes less risky as the business moves further away from the “proof of concept” phase. A company that hasn’t raised any money and has no revenue is very risky, because the business is basically just an idea at that point. If the company has closed an investment round, they’re significantly less risky, because someone else viewed the business as a worthwhile investment (but still very risky relative to larger, more mature companies that are publicly traded).

Forms of Equity Compensation

Generally, “equity” in this context refers to an ownership stake in a company. Companies can issue equity to service providers (employees, consultants, advisors, etc.) in order to give them an ownership stake that entitles them to participate in the success of the company.

The most common forms of equity awards in the U.S. are restricted stock, restricted stock units (RSUs), stock options (you get the option to buy the stock at a predetermined price in the future), and stock appreciation rights (SARs). Each of these forms of equity awards are treated as securities by the U.S. Securities and Exchange Commission (the SEC), which is important because it means that they are taxed differently than cash compensation. 

Tax Implications of Getting Paid in Stock

The tax treatment for equity compensation depends, in part, on the type of equity award you receive. For example, restricted stock grants are generally taxed at the time you receive the grant, whereas stock options are taxed either upon exercise of the option (when you exercise the option, that’s when you ultimately decide to buy the stock) or upon the sale of the stock. It’s important to understand what type of equity award you are getting so that you know how it will be taxed.

The basic idea is that when you receive something of value in exchange for services you’re providing, that compensation will be taxed by the federal and state governments in the U.S. The tricky part is understanding when the government says you “received” the equity award. Some equity awards are grants of stock (like restricted stock), so when they are granted to you, you receive the stock immediately. Other equity awards are rights to acquire stock (like stock options) so you don’t receive the underlying stock until you exercise the right or until the right is triggered. In many cases, there are also vesting requirements that distribute the equity award to you in portions as you achieve certain milestones or time commitments.

In addition to the tax that you may incur when you receive the equity award (income tax), you will likely also incur a tax when you sell the equity (a capital gains tax, similar to what you pay if you trade equities or crypto). Generally, you will be taxed on the gains, which is the difference between the sale price and the price you paid/the value of the award at the time it was granted to you. It can be difficult to determine the value of the equity award you will receive, particularly if the company is private (if the company is a publicly-traded company, you can check the public stock market listing for the price per share of company stock). You can ask the company to provide you with valuation information so you can properly assess the value of your equity award, but private companies might not have much information to give you. In all cases, it’s a good idea to discuss with a qualified accountant or qualified tax attorney to understand the tax implications of the equity awards you will receive and the questions to ask the client company.

An Overview of Vesting

Equity awards are really just contracts between the company issuing the award and the recipient. The terms of these contracts generally cover things like who is eligible to receive the equity award, how the equity will be distributed to the recipient, what happens when the recipient stops providing services to the company, and notably, any vesting requirements. 

Vesting is one of the more talked-about topics because it determines when the recipient receives the equity. A vesting schedule means the company is distributing the equity to the recipient in portions based upon the achievement of certain milestones or over time, rather than in one lump sum up front. For example, a common vesting schedule for a stock option grant to an employee by a private company in the U.S. is equal monthly installments over four years, with a one-year cliff. This means that the recipient will not receive any portion of the stock option grant for the first year, but then on the first anniversary of the grant date (the “cliff”), they will receive 12 months’ worth of the stock option grants. After that first anniversary the rest of the grant will vest, or be distributed to the recipient in equal portions, each month for the remaining 36 months. If the total grant is for 6,000 stock options using this vesting schedule, the recipient would receive none of the stock options during the first year, then 1,500 options on the first anniversary of the grant date, and then 125 options per month for the remaining 36 months after that.

Vesting schedules can be used with any type of equity award and it can have a major impact on the tax treatment for the recipient when you consider the value of the grant. Let’s say you have a client with a really long project and they offer to pay you in a combination of cash and stock. They decide to grant you $12,000 in stock up front, that vests every month throughout the year so long as you continue working on the project. In this instance, even though the $12,000 in stock is granted up front, you don’t actually earn it all then. Vesting means that you earn a portion of it over the vesting period. So, in this instance you earn 1/12th each month, or $1,000 a month. For income tax purposes, you would report $1,000 in income from the stock grants each month.

For high-growth start ups, this can have some unintended consequences. Let’s say that when you agreed to the deal that the company was only worth $10M. If they do a fundraising round during the year that valued the company at $100M, the company’s stock price went up 10x. That means that the shares you agreed to be paid in also increased 10x in value, so instead of earning $1,000 a month you’re earning $10,000 which is a much higher tax bill than you budgeted for!

If you’re granted equity that vests over a long time period, there is a solution that helps minimize this risk. You can file an 83(b) election with the IRS within 30 days of getting the stock grant. This is a one page document that outlines the terms of the grant. Most importantly, it allows you to recognize the income at the valuation in place at the time of the grant. So, if the company increases in value while your stock is vesting, you’re locked in at the original valuation! This minimizes the potential adverse tax hit to you.

In our prior example, if the company raised the money in June, then a person without an 83(b) election would have income of $1,000 per month from January through June, and $10,000 per month for the rest of the year. If you filed an 83(b) election, you’d recognize the income at the original $1,000 per month for the entire period.

Then, if the company was a success in the future, you’d pay capital gains on any appreciation. Let’s say the company IPO’d and the $1,000 of stock you received in one month was now worth $25,000. You’d pay capital gains taxes on that profit when you sold the shares: the $25,000 sale price, less the $1,000 stock basis = $24,000 in profit subject to capital gains tax. For the filer without an 83(b), the stock he recognized at $10,000 (and paid income taxes on) would have less capital gains tax ($25k – $10k = $15k profit taxed at the capital gains rate). However, it’s important to remember that (a) the capital gains tax rate is less than income tax rate, so you’ll be paying less taxes overall by using the 83(b) election, (b) you pay the capital gains tax in the future when you sell, instead of paying income taxes today on the equity grant, and a $1 today is worth more than $1 in a few years, and (c) you’re paying the capital gains tax if/when the company is a success, at which point you’ll sell the shares and actually have the cash to make the payment. 

Accepting an Equity Award

If you decide to move forward and accept an equity award as compensation, you’ll want to build this into the services agreement you have with the client just like you would with cash compensation. The contract should state that, in exchange for your services, you will receive $X in cash and Y number of shares, options, etc. in equity. You will generally also want to outline the terms of the equity award, including any vesting requirements, in the services agreement so that there are no surprises down the road.

After you sign the services agreement, the client will issue you the equity award. This could take some time if the client needs approval from their board of directors, but this is usually done shortly after signing the agreement. The client may issue you the equity award as a document emailed/mailed to you, or they may use an online platform like Carta or Shareworks to issue you the award. There is generally no difference between receiving an equity award in a physical format, as a digital document, or as an electronic certificate on an equity management platform. The grant certificate will sometimes reference and be accompanied by related documents like the equity plan that governs the award, and any related grant notices. 

You will generally be asked to sign the equity award which signifies accepting the terms of the award. Sometimes you can negotiate these terms and sometimes the company will take a hard-line stance. It never hurts to ask them to make the terms more favorable, but don’t expect many changes; equity awards are usually distributed with the same terms to everyone. Many companies are more flexible when it comes to the number of shares, options, etc. and sometimes the vesting schedule. Both can impact the overall value of your award so be sure to discuss with a qualified legal or financial advisor to understand the best way to position yourself and how to negotiate.

Conclusion

If someone offers you stock as a form of compensation, it can still be a viable form of payment. Any startup investment is risky, so just go into the arrangement with eyes wide open. Whether it’s a passion project you’re helping a friend on, or just a little extra the client offered to give you in addition to cash, it’s important to know the implications for your taxes. If it vests, remember to file the 83(b) election within 30 days of the grant. With this guide, you should be good to engage clients regardless of their preferred form of payment. As always, if you have any questions don’t hesitate to let us know how we can help!

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