Share grants would be seen as income by the IRS and most states and taxed at their Fair Market Value. Options on the other hand usually qualify as Incentive Stock Options that aren’t taxed at grant time and “when exercised, it isn't necessary to pay ordinary income tax. Instead, the options are taxed at a capital gains rate.” [1]

Options are better up front because there is no outlay for the employee. They are a hassle down the road. However, if you exercise during a liquidation event your tax liability is probably covered.

Stock is a pain upfront unless granted before the first round of funding or any real revenue when the stock value is very little. They are easier down the road, though.

Just my two cents. HackerNews, please correct any errors in logic or how this stuff works.

1. https://www.investopedia.com/terms/i/iso.asp

You are taxed at your marginal rate on the value between when they are offered and you exercise, and on the capital gains rate (provided you hold them long enough) between when you exercise them and sell them

In practice you either buy them the day they are offered (but before they vest, so a gamble) to switch to the CGT rate asap, or exercise and sell in the same process which means you pay at your marginal rate. You tend to do the former if you are early series A (penny a share or so so low financial risk - for example I once paid $1000 for 100k founder's shares), and the latter otherwise. Doing something in between means a largish tax liability with no matching liquidity event to pay for it - during the first dotcom bubble a lot of people did this, got a huge unexpected tax liability at the end of the year (and AMT) AND lost their jobs as things crashed and their stock became worthless (they could write that off in the next year, but owed the IRS lots of money while unemployed) ... so be careful here, make sure you know what you are doing if you're exercising in a situation that's not one of those first two I listed.

Companies should either:

- award RSUs that have a liquidity event as the final vesting requirement and don’t expire (so you are not taxed until you can sell, and don’t risk losing what you already earned), or

- pay annual cash bonuses that are “grossed up” so that the after-tax amount of the bonus is enough to cover the taxes levied against the employee’s value of actual stock or vested RSUs, etc., and ensure the company bears that tax burden.

I’d be more forgiving to fully bootstrapped companies, which are often fairer to employees anyway.

Not willing to compromise at all for VC-backed companies, period. They also should be paying full market wages and the equity portion is solely meant to be competitive with the equity compensation or bonuses at public companies.

The IRS considers RSUs that don’t have an expiration date as being close enough to actual shares to be taxable income. There has to be a “substantial risk of forfeiture” to qualify for deferred taxation.

In that case, then only the second suggestion.

That's usually referred to as Phantom Stock, and is a thing.

>Instead, the options are taxed at a capital gains rate

As I understand it, they ARE taxed as income for all intents and purposes at exercise time (based on the value difference at exercise). They are not regular income but they are part of Alternative Minimum Tax income. You pay taxes on the greater of the two. The difference between exercise price and sales price is then taxed as capital gains assuming you held the stock for a year (or two?).

The one trick to this is that if you exercise very early then the tax is on basically nothing (literally nothing if your option price and current value are identical). However, you still need to buy the options so it's not free but just tax free.

Another trick, if it makes sense at the time, is to work out what your AMT threshold will be and only exercise enough options to keep it at 0 or something you're comfortable with.

This is especially useful if you have ISO's currently vesting and the company has since gone public.

One problem with startup RSU is limited liquidity. If you got $1M RSU and have 25% tax rate then you need to drill a hole for $250K in your bank balance right away. If private market exist and you can sell 25% of your grant, that probably works but otherwise the $1M RSU sits there just looking pretty next to that ugly hole you just drilled. Now if company goes down for any reason then that's $250K not coming back possibly not just making you work for peanuts but you might have paid out of pocket to work at that company, i.e., received a negative salary. With stock options the same outcome could occur. The great outcome occurs if you got stock options and stick around all the way until successful exit. This would be desirable by founders and investors but things may not be under your control because, you know, life happens.

This basically means that to avoid negative salary outcome startups must arrange so at least portion of grant can be sold privately to cover tax liability at the time of grant in case of RSUs or at the time of exercise in case of stock options.

If this condition is not met, trade waters very carefully.

Maybe this used to happen earlier, but I only really saw this after the DotCom bust. In my case it was founders/execs issuing themselves new/preferred stock and diluting all their coworkers into oblivion on an exit.

Granted, these were small shops ~30 people and the exits were small ~$100M, but the effects were devastating. Everyone who could quit, did. People for whom an extra few $100k would have been a big deal would throw drinks at founders in a bar. The code became an unmaintainable worthless mess and they basically failed to live up to the value they existed at.

Why would someone give the founders such a deal? If they don't care about their employees to share 10%, they probably don't care about even medium term success.

I lived through an experience very similar to this. The little people got peanuts. Two things really burned me. One was exactly the point you made, with such a small team it would haven't been much to make the payout go from pathetic to meaningful for the peons who put years into the company. Second the sale contract specified employees would continue to receive similar salaries. So our salaries did not change, options that took years to vest were cashed in for little money, and the company suddenly had plenty of extra money to go on a hiring streak.

Could you/should you ask founders if they have such unilateral dilution powers? How do you check for this when joining a startup? Should this be explicitly written in the offer letter you get?

In general a majority stock holder(s) can rewrite the rules any way they like. You could have a poison pill written into your offer letter (requiring an immediate payout for certain events), but I don't think any founder/VC would sign it.

But I AM NOT A LAWYER.

A lot of smaller/early stage/seed startups actually do this. It's a restricted stock grant. And for the people saying they don't do it because of taxation on an illiquid asset, this is why 83(b)'s exist. They let you pay the full tax on a stock grant at time of the grant, not time of vesting.

You get a 409A valuation to establish the Fair Market Value of your stock. That valuation isn't based on the same criteria that investors use, it is much more rigorous and based on income, cash in the bank, etc. You could very well have a company raise money at at $10MM cap and be "worth" less than $1MM. If you grant someone stock at that price, their taxable income will be negligible - usually only a few hundred to a few thousand dollars, and then they don't have a giant tax bill at the end.

You still have to pay capital gains, but that only applies when you sell the stock, so you have the money to pay it.

That only works if you're a really early employee. Most moderately successful companies reach the point where their equity grants are worth enough that the exercise cost plus tax bill for an early exercise will be in the thousands.

> Why don't startups offer actual equity grants instead of options?

Great tax advantages. For ex one startup I worked for did it the other way resulting in recognizable tax income and everyone got hit with a tax bill. Fortunately when it was brought to leadership's attention they were enlightened enough to offset the tax bill with cash but don't expect that, ever.

Because you'll be taxed on something that often has no liquidity nor market. The estimated value on your stock may be $5 and you'll get taxed on that but if you were to go sell it you may only be able to fetch a fraction of that on the secondary market (if there is even one for those stocks), possibly not even covering the taxes you have to pay.

Late stage private startups almost always grant RSUs. If they didn't it would be way too risky for most people to join because the cost to exercise would be very high.