A solution halfway to the future…
Once the company is up and running with outside funding or revenues, you will not give employees shares, restricted or otherwise. Rather, you will give them stock options. A stock option is the right to buy shares in the future at a fixed price, set at the time of the grant, the so-called “strike price.”
The reason is that the IRS considers grants of shares to have value, even if there are no buyers for those shares (which is the typical case for a private company), and that value is taxable as income. Once a company is funded or has paying customers, it has a value.
As these stock options and warrants may never be “exercised,” (i.e., converted into shares), the IRS does not consider them valuable until they are converted into shares, at which time you’ll need a tax accountant to explain the rules.
If you are recruiting people into your team, it may be better to keep the founders’ shares to just the founders and set up all the recruited team members with stock options.
RULE 13:
For recruited team members, stock options may be better.
The stock option grants can include the same cliffs, forward vesting, and other details outlined above.
One benefit of stock options versus restricted shares is that stock options can be owned only by employees. When an employee leaves the company, he or she needs to either “exercise” the options or abandon them forever. The hurdle of exercising the options and paying taxes on the value of those shares often prevents unhappy employees from becoming minority shareholders.
The downside of options is that they are another layer of complexity. They will add to your startup expenses as you work with an attorney to create the necessary documents, and they will add complications to explanations of why certain people are receiving shares while others are receiving options.
Warrants
Only employees are allowed to own stock options in a private company. For non-employees, including contractors, there are “warrants.” These too are the right to buy shares in the future for a price set at the time the warrants are issues.
Outside of taxes, they are basically the same as options, except that, unlike options, they can be owned by non-employees. Warrants are typically given to lawyers, accountants, and other vendors as a form of payment in lieu of cash.
For this equity split conversation, they can be used in lieu of restricted shares, if your recruited team members are consulting for the company rather than joining as employees.
A short-term, three-, six-, nine-, or twelve-month contract is not uncommon as a means to recruit an early team member. But do note that, rather than complicate the conversation with warrants, you can simply use a “cliff” on a grant of unrestricted shares to reward them for their short-term effort.
