Choice between equity and stock options

Question

I am part of a tech startup and have just been brought on as the technical co-founder. My compensation is 100% equity for now, but I will likely be hired with a salary in the near future.

The problem is that the company does have a bit of value already, so I have been given the choice of receiving stock or stock options.

If I understand it correctly, if I choose stock (83b?) that there will be consequences on next year's taxes. For example, say I own 10% of the company and the company is worth $300,000, then I will have to claim an additional $30,000 of income on my taxes, and probably end up owing the IRS. Also, If I later sold the shares for say, $100,000, what would taxes look like then?

It's the stock options I'm not sure I understand. I do understand that an option means that I don't own the stock yet, but that I can purchase it later at the strike price which, given my previous example, is $30,000. So, hopefully down the road, the company value will be worth more, say $1,000,000, so at that point, if I wanted to exercise my options, I could pay $30,000 but then turn around and sell those shares for $100,000 for a $70,000 profit. So at this point, would $70,000 be the amount added to my taxable income?

The other thing confusing to me is my partner, who doesn't know a ton about this either, keeps saying that if I choose options, I won't have to pay anything when I exercise them because I will be paying for them with my "sweat equity" (aka working for the company without pay), but it seems to me, that's not how stock options work and unless I get it in a contract that the company will pay my strike price when I exercise them, I will have to come up with the strike price myself. Is that right?

Are there any other considerations when making the choice between stock vs stock options?

Answer 1

Restricted stock: You receive the stock at no cost but pay taxes on the value as the shares vest. If you make an 83(b) election, that pulls the tax burden to today instead of as you vest, so you'll have additional income of $30,000 and pay taxes on that today. At sale, you'd have a capital gain / (loss) on everything above / (below) $30,000.

Options in general: at grant, the exercise/strike price must be at or above the current fair market value (generally the 409a valuation for private companies), or there are pretty nasty tax penalties that companies try to avoid. In your case, that would mean your exercise cost = FMV = $30,000. You could early exercise and make an 83(b) election, which would mean you'll pay $30,000 out of pocket (your exercise cost) plus $0 in taxes (FMV - exercise price = $0, so no additional income). Otherwise, you'll only have to pay if/when you choose to exercise.

There are differences in the tax rules between incentive stock options (ISOs) and nonqualified stock options (NSOs) too.

If you know you want to file an 83(b) election and take on the risk of owning startup stock, a restricted stock grant would be better (paying taxes on $30,000 of income is better than paying $30,000 directly out of pocket). If you aren't sure or don't want to pay anything now, options might be better since you retain more timing flexibility.

There's a lot more to it than that, but at a very high level that's the main difference you'll have in deciding between restricted stock and options.

I'd suggest consulting an attorney with equity compensation contract expertise. You want to make sure that you're getting what you expect and there's nothing in your contract or grant agreement that can screw you over down the road.