The Startup Financing Cycle
Over the past few years, I’ve used the above image every time I’ve given a presentation to advisors on how stock compensation works and the things to consider.
I know it’s a graph about financing, but financing is also when YOU get an opportunity. Whether it is VC funding, Institutional funding, a Merger/Acquisition, or the public funding you in the IPO market. These stages also correlate to the types of stock compensation we see.
At the beginning, there is little revenue and assets, so stock tends to be $0.001/share. The founders will own stock and may acquire additional shares as funding begins to prevent dilution. The business attorney(ies) will track the stock certificates and make sure any vesting options given to founding team members come with an 83(b) election so you can minimize taxes at exercise and start the clock on long term capital gains and potentially qualifying for the QSBS exclusion.
After funding, the company can now think about a long term incentive plan for employees and how much of the total stock can be designated to an employee pool for stock compensation. We tend to see a mix of Incentive Stock Options and Non-qualified Stock Options based on a few things: the lead VC funding the deal (they have their own structure they prefer), the founders preferences, and how quickly the valuation of the company is blowing up.
Incentive Stock Options (“ISOs”) allow employees to exercise shares without immediately recognizing compensation income. The flip side is, there is something called AMT that you could still owe depending upon the total value received. However, with a little planning, you can optimize for minimal AMT and long term capital gains tax rates on the value. ISOs are definitely special, and anything special and taxably favorable tends to have a limit in benefit 😉 When ISOs are granted, they cannot provide more than $100,000 in value per year of the grant… So for top executives, you may still see Non-Qualified Stock Options (“NQSOs”) present in offers or annual true ups.
This is also a great time to go into a company with strong negotiation power as a top executive providing great value: we work with clients to get acceleration triggers put into their contracts for 50% or 100% accelerated vesting in the event of an IPO or merger. Your blood and sweat deserve recognition!
[Stock Appreciation Rights (“SARs”) are still a thing too! Just unbelievably intangible since it’s up to the Board of Directors to ‘approve’ a payout]
As the company matures, compensation tends to move towards double trigger RSUs as the main form of compensation for the majority of employees. ISOs or NQSOs may still be in the mix, but we are seeing more and more of these double trigger RSUs now with the strong IPO/DPO market.
Double trigger RSUs are generally taxable compensation income when two events occur: 1. The time vesting requirements have lapsed and 2. There is an ‘exit’ event. When these two things happen, there can be a large amount of income recognized in one year. So sadly, we often find clients hit a top tax bracket quickly in the year of IPO or Acquisition with little ability to offset it beyond maxing out 401(k)s, HSA, etc.
If you are in California, the biggest shocker can be the requirement that over $1 million in taxable income, they expect you to pay at least 90% of expected taxes in during the year or you can be subject to a nice big penalty.
Over the last few years, the stock market became much more accessible to tech companies. Instead of needing to negotiate with a middle-man bank to launch an IPO, direct listings and SPAC deals increased. Each of these deal types has it’s pros and cons for how to come at the stock sale strategy based on historical statistics and the companies (and their financial condition) that choose to go a specific route.
Employees will be subject to extended lock up periods, but may have the benefit of an initial 20% to 25% sale option on the first days of trading.
Check out our ‘Going Public?’ page for more information on how to prepare for going public.
Once the tech company is a few years out in the public market, we often see the changes to planning towards annual RSU compensation adjustments, ESPP plans, after-tax 401(k) options, charitable matching and Deferred Compensation plans. Each company may be a bit different at this point based on their individual missions and company goals for employees.
Disclosure: Recommendations are of a general nature above and are not based on knowledge of any individual’s specific needs or circumstances. There is no intent to provide individual investment advisory, supervisory or management services.
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