Key Takeaways

  • An equity grant gives ownership in a company as a form of compensation, often used to attract, retain, and motivate employees.
  • Grants can include stock options, restricted stock, RSUs, or phantom stock, each with specific tax and legal implications.
  • Vesting schedules are key to ensuring long-term commitment and can vary by company.
  • Equity grants must comply with securities laws and should be documented in formal plans and agreements.
  • Companies must follow rigorous internal controls and legal procedures when issuing equity to prevent compliance risks.
  • Tax treatment varies by equity type; consulting an attorney or tax advisor is often necessary.
  • Recipients should consider exercising strategies and exit planning for vested equity.
  • Private companies may use 409A valuations to set fair market value for option pricing.

What is an Equity Grant?

An equity grant, also referred to as equity compensation, is a non-cash payment provided to someone. Essentially, the receiver is being granted equity in something. Normally, the equity will be in the company the person works for.

Reasons Companies Offer Equity Grants

Companies offer equity grants for several strategic reasons beyond cash compensation. These include:

  • Attracting and retaining top talent: Particularly in startups or cash-constrained businesses, equity is a powerful tool to bring in skilled professionals.
  • Aligning employee interests with company performance: Granting ownership fosters a shared goal of increasing the company’s value.
  • Conserving cash flow: Especially beneficial for startups or early-stage companies.
  • Creating long-term incentives: Equity grants often come with vesting schedules that encourage employees to stay and contribute to long-term growth.
  • Rewarding performance: Equity awards can be tied to achieving specific goals or performance milestones.

Equity Incentives to Employees

Today, many companies are continuing to search for new ways to both motivate and compensate its employees without using cash. Some companies are responding to this challenge by providing equity awards or stock to its employees to keep them happy. While many companies already have something in place for a number of employees, those companies out there that don’t currently have it set up are now looking to do so. Adding an equity compensation plan is imperative for the future of your business, especially if you are just starting-up.

It is important to know that granting equity to employees can raise several issues, including legal, tax, corporate, and contract implications for both the employer and the employee.

Common Equity Grant Vehicles

Employers have multiple tools for granting equity. Each comes with different legal, tax, and accounting considerations:

  • Incentive Stock Options (ISOs): Common in startups; favorable tax treatment but strict rules.
  • Non-Qualified Stock Options (NSOs): More flexible, but may trigger ordinary income tax.
  • Restricted Stock Awards (RSAs): Actual shares subject to vesting; taxes due at grant unless an 83(b) election is made.
  • Restricted Stock Units (RSUs): Rights to shares delivered upon vesting; taxed at delivery.
  • Phantom Stock/Stock Appreciation Rights (SARs): No actual ownership; cash-based awards tied to stock value.

Employers often document these in formal equity incentive plans, tailored to corporate goals and subject to board or shareholder approval.

Issue #1: Will the Equity Grant be Given Under an Employee Plan?

Although some companies grant equity on an informal basis to its employees, most companies offer stock options under the employer plan, which is subject to the approval of the company’s board of directors and, at times, the company’s shareholders too.

These plans, also referred to as stock option plans, equity incentive plans, or stock incentive plans, explain in detail the type of equity offered, the maximum number of shares being provided to the employee, and the guidelines relating to the grant. The plans are tailored the company’s goals and objectives.

Be mindful that equity plans are not the same as employee stock ownership plans, which are tax-qualified employee benefit plans that buy and hold employer stock for the benefit of the plan participants. 

Internal Controls and Grant Procedures

To avoid legal and regulatory pitfalls, companies must implement strict internal controls when granting equity:

  • Board approval: All grants should be documented and approved by the board of directors.
  • Grant dates and pricing: Must be clearly defined and aligned with the company’s valuation and stock plan.
  • Formality of grant documents: Award letters, grant agreements, and cap tables should be consistently maintained.
  • 409A compliance: For private companies issuing options, a 409A valuation must set the fair market value.
  • Avoiding backdating issues: Proper documentation ensures legal grant dates and avoids tax penalties.

Issue #2: What Type of Equity Grant Will I Receive?

Generally, equity is granted in the following ways:

  • Written award agreement
  • Certificate
  • Direct grant of stock, specified in the employee’s contract of employment
  • Option, which is an option to purchase the employer’s stock in the future for a specified price
  • Phantom stock, which is a bonus provided to the employee that is based on the value of an employer’s stock on a future date

Equity Grants to Founders vs. Employees

While employees typically receive equity grants through formal incentive plans, founders often receive larger initial equity allocations:

  • Founders: Typically granted common stock at or near company formation. Subject to vesting to protect the company from premature exits.
  • Employees: Generally receive options or RSUs. Grants are smaller but can grow over time with promotions or performance.

Both types of recipients should be aware of the vesting schedule, dilution impact, and long-term implications of ownership.

Issue #3: How Do Securities Laws Apply to my Equity Grant?

Generally, federal and state securities laws require that the sale of stock, or other similarly situated securities, be registered with the Securities & Exchange Commission (“SEC”) as well as any relevant state securities agencies unless the offer itself fits into one of the statutory or regulatory exemptions. This principle applies for equity grants too. With that being said, an exemption almost always exists when a company offers options or stock to employees.

Publicly held companies generally file an S-8 Registration statement with the SEC to register such employee equity grants. However, if the company chooses not to file this form, the equity grant must be structured in a way to avoid registration. While it may seem as though a company is acting unethically by trying to fit within a registration exemption, it is perfectly normal for in-house counsel and senior management at the company to find exemptions to avoid the hassle and paperwork of filing with the SEC.

Issue #4: Will the Equity Vest?

Yes. Most equity grants will vest at some point in time. Vesting simply means that the right given to you is now a right that you can take freely without any conditions. Generally, the employer will require that the employee remains with the company for a specific period of time before the equity will vest. Once the equity has vested, however, the employee can leave the company without losing any financial compensation that was gained while employed with the company. Therefore, the benefit is fully vested.

Take, for example, a business that provides its employees with 1 percent of the company’s shares. Now assume that the company has a five-year vesting period. Therefore, if an employee leaves the company before the five-year mark, he will lose his 1 percent interest in the company. However, by year six, he can leave the company for another opportunity, and still own 1 percent of the company.

The most common type of vesting takes place over four years. No equity will vest for a one-year period. On the one-year anniversary of the date the equity is granted, 25% will vest. The remaining 75% vests in 36 equal installments on a monthly basis.    

Vesting Acceleration and Termination Provisions

Equity grants often include provisions that address what happens upon termination or company events:

  • Single-trigger acceleration: Accelerates vesting upon a merger, acquisition, or IPO.
  • Double-trigger acceleration: Requires both a change of control and termination of employment without cause.
  • Termination clauses: Most grants include terms for forfeiture upon voluntary resignation or termination for cause.
  • Cliff vesting: No equity vests until a specific initial period is reached (e.g., one year).

These terms are critical to understand when evaluating the value and risks of your equity grant.

Issue #5: How Much Equity Will I Receive?

The one thing you should know about the equity grant that was provided to you is the percentage being offered. Simply put, how much of the company are you being granted? The number of shares doesn’t necessarily matter, but the percentage does in fact matter. Make sure that, before joining a company, management advises you of the percentage.

Issue #6: When Does the Grant Expire or Terminate?

If you receive an option, the option agreement will provide an expiration date, at which point in time that option can no longer be exercised.

If you receive an equity grant, the agreement will provide dates regarding when the grant vests, the percentage, and number of shares.

Issue #7: How Are Equity Grants Taxed?

This answer depends on what type of equity is being granted. Unrestricted Stocks are taxed. Restricted Stocks are not taxed until the equity vests. Options are a bit more complex. See a more detailed explanation below.

Unrestricted Stock

Yes, unrestricted stock is taxable. The amount taxed is the fair market value of the equity received, even though the employee doesn’t have the cash in hand.

Restricted Stock

No, restricted stock is not taxed until the equity vests. Therefore, if the fair market value of an employer’s stock increases annually, so too will the employee’s tax liability. In this case, you as the employee could file IRS Section 83(b) within 30 days of the grant. This form requires the employee to pay taxes on all unvested restricted shares based on the fair market value of the shares at the time the equity is granted. Therefore, the employee will not have to pay taxes on the vested amount, which would be considerably higher as the fair market value is expected to increase over time. 83(b) elections are incredibly important and should be included in the equity compensation plan.

Option

If the option has an exercise price equal to the fair market value of the stock at the time of the grant, then the employee will not be taxed the same year that the grant is given to the employee. But, once the option is exercised, the employee will be taxed on something called the spread. The spread is the difference between the exercise price and the value of the shares at the time the option is exercised.

Tax Planning Strategies for Equity Recipients

Tax treatment of equity grants can significantly impact take-home value. Consider the following strategies:

  • 83(b) Election: For restricted stock, filing this election within 30 days of grant allows tax on current value rather than future appreciation.
  • ISO holding periods: Holding ISOs for at least two years from grant and one year from exercise can qualify gains for capital gains treatment.
  • Alternative Minimum Tax (AMT): ISOs may trigger AMT if exercised and not sold within the same year.
  • Net exercise vs. cash exercise: Different exercise methods can affect liquidity and tax liability.
  • Tax withholding: RSUs and NSOs may require immediate withholding upon vesting or exercise.

Given the complexity, consulting with a tax advisor or attorney on UpCounsel can help optimize tax outcomes.

Frequently Asked Questions

  1. What is the difference between RSUs and stock options?
    RSUs are promises to deliver stock in the future and are taxed upon vesting. Stock options give the right to buy shares at a set price.
  2. Can I lose my equity if I leave the company?
    Yes, if your equity hasn’t vested, you may forfeit unvested shares. Vested shares are typically yours to keep.
  3. What happens to my equity if the company gets acquired?
    It depends on your agreement. Some plans offer acceleration, while others may convert your equity into equivalent value in the new company.
  4. When should I exercise my stock options?
    Timing depends on factors like the company's growth outlook, tax implications, and your financial situation.
  5. Do private companies need to register equity grants with the SEC?
    Most private company equity grants qualify for exemptions under securities laws and don’t require SEC registration.

If you need help with an equity grant or would like to speak to a qualified attorney in this area, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.