Alternative Equity Compensation: Guide for Startups

Equity compensation in startups is generally issued in the form of a restricted stock grant (RSA) or a stock option. Every once in a while, startups may consider alternative equity compensation. This article will help you understand the alternative equity compensation options.

Since these are much more rare, founders should definitely work with counsel to design and execute these equity compensation schemes. If you are looking for counsel, feel free to reach out to us here.

Phantom Stock in a Startup

When it comes to equity compensation in startups, phantom stock is a relatively uncommon but useful tool to reward employees. It is a mechanism to offer employees the financial benefits of stock ownership without giving them actual shares of company stock. These shares don’t provide ownership rights, but they do entitle employees to economic benefits since their value rises and falls in accordance with the company’s stock.

• Stage of Company. Phantom stock is beneficial for early-stage startups that want to retain their employees without diluting the company’s ownership. Since the startup is in its early stages, it may not have the financial resources to offer traditional stock options to its employees. 
• Vesting. Like other forms of equity compensation, phantom stock can also have vesting milestones that the employee must achieve to claim the benefits. The vesting schedule can be customized according to the startup’s needs and can be performance-based or time-based. However, it is essential to make sure that the vesting milestones are achievable and in line with the company’s objectives.
• 83(b) Election. Unlike other equity compensation plans, phantom stock does not require an 83(b) election since it is not actual stock. Therefore, employees do not have to worry about the tax implications of phantom stock.
• Termination. In case of termination, phantom stock differs from other equity compensation plans. The company can decide to pay out the employee’s phantom stock benefits or not, depending on the circumstances of the termination. In some cases, the startup may decide to pay out the benefits in full, while in other cases, the benefits may be forfeited.

This customizable option may be an attractive offer to employees interested in equity compensation if stocks aren’t available.

Stock Appreciation Rights in a Startup

One of the less common forms of equity compensation is stock appreciation rights (SARs). SARs give employees the right to receive the increase in the company’s stock price over a specified period. These are the key features of SARs and how they can benefit startups.

• Stage of Company. SARs are most commonly used by later-stage startups that have a high fair market value (FMV). Since SARs are based on the increase in the company’s stock price, they are not a suitable form of equity compensation for early-stage startups. 
• Vesting. Like other forms of equity compensation, SARs can have vesting milestones that employees must achieve to claim the benefits. Vesting milestones can be customized and can be performance-based or time-based. However, it is essential to ensure that the vesting milestones are achievable and in line with the company’s objectives.
• 83(b) Election. An 83(b) election is a tax election that an employee can make when they receive stock. The election allows the employee to pay taxes on equity compensation at the time of the stock grant rather than at the time of vesting. Since SARs are based on the increase in the company’s stock price instead of actual stock, they do not require an 83(b) election.
• Termination. In case of termination, SARs differ from other forms of equity compensation. SARs can be structured as either cash-settled or equity-settled. In an equity-settled SAR, the employee receives company stock instead of cash. In a cash-settled SAR, the employee receives cash equal to the increase in the company’s stock price. If the SAR is equity-settled, unvested SARs are generally forfeited back to the company. If the SAR is cash-settled, the company must pay out the cash benefit.

For early-stage startups, stock options or RSAs are generally a better option than SARs.

RSUs in a Startup

RSUs are a popular form of equity compensation that many startups use to incentivize their employees. 

• Stage of Company. RSUs are more suitable for later-stage startups with a high FMV. Startups that have already established themselves and have a higher valuation can offer RSUs as an attractive form of equity compensation. 
• Vesting. RSUs are a promise by the company to issue stock after certain vesting milestones have been achieved. Although both RSAs and RSUs can have performance-based vesting milestones, they are more common in RSUs. The vesting schedule can be customized according to the startup’s needs and can be performance-based or time-based. However, it is essential to ensure that the vesting milestones are achievable and in line with the company’s objectives.
• 83(b) Election. RSUs don’t require an 83(b) election because the shares are issued without restriction once the vesting milestone is achieved. This means that employees do not have to worry about the tax implications of RSUs when they receive them. However, it is essential to consult with a tax advisor to understand the tax implications of RSUs upon vesting and sale.
• Termination. RSUs that are unvested are forfeited back to the company immediately, without the need for the company to repurchase them. In case of termination, RSUs differ from other forms of equity compensation. Unvested RSUs are generally forfeited back to the company, and the employee does not receive any benefits. However, some startups may offer a prorated benefit to employees who are terminated before their RSUs have vested.

Early-stage startups may not always have the financial resources to offer RSUs. Other forms of equity compensation, such as stock options, may be more appropriate.