Lots of people are very confused about equity compensation. It can be a convoluted and tricky process. I've edited this summary below, which can run you through the options.
Big shout out to Terry Mosteller for creating the original document!
All options require a business valuation. We also assume here that this is an S-Corp.
Option 1: Employee Purchase of Shares
Requires Employee to either have resources to purchase through (a) cash or (b) financing.
Option 2: Employer Grant of Shares
Employee would recognize income on the value of the shares. This could be expensive because it could result in a sizable tax liability. And in most cases, you won't have any additional cash to pay those taxes.
Option 3: Phantom Stock Plan
Employer promises to make Employee a cash bonus payment in the future, based on the number of phantom shares granted and the value of shares of the company stock or the increase in the value of the shares over a specified period.
Employee pays no tax when these phantom stock shares are granted.
Employee receives no actual ownership in the company.
Compensation would be taxed as ordinary income, versus capital gain treatment for a true ownership interest.
It's sort of like having the cash benefits of being an owner without actually being an owner.
Option 4: Stock Appreciation Rights
Allows Employee to participate in the growth of the stock price. This is generally by paying Employee cash for the increase in the value of a certain number of shares of company stock over a predetermined period or at the time Employee exercises his rights under the plan.
Employer can pay in actual shares instead of cash.
Can also have built-in tax issues as well.
Option 5: Stock Options
Allows Employee to purchase shares in the future at today's value (or some other stated price).
Can have favorable tax treatment for Employee. If we give them options at today's value and the price goes up, they can make money exercising those options. If it doesn't, they won't, and the options are worthless.
Requires Employee to have cash to exercise the option.
Option 6: Tandem Stock Appreciation Rights (Combine Options 4 and 5)
Not surprisingly, it's complex.
It is typically granted to make it easier for Employee to come up with the cash to pay the option exercise price. Basically, I can give you SARs, which means I owe you cash - and then you can exercise options, which means you owe me cash. So we net it out.
To the extent, Employee exercises tandem SARs, an equal number of the corresponding options are typically canceled. For example, assume Employee is granted both:
An option to purchase 100 shares of company stock.
100 tandem SARs.
If Employee exercises 60 SARs to be able to pay the exercise price of the option, the company then cancels the option with respect to 60 shares of common stock.
Employee then uses the tandem SAR proceeds to exercise the option to purchase 40 shares of company stock.
Option 7: Liquidate S Corp and Restructure as a Partnership
Can have significant tax implications on the current shareholder, also on the new partner.
This has three scenarios:
- Employee can purchase partnership interest (requires cash) (See Option 1)
- Employee can be granted a capital interest (See Option 2)
- Employee can be granted a future profits interest (Most common option)
Receives a portion of future profit
Not taxable at the point of granting the interest, if certain criteria are met
Note that this means they have no value/equity day one. They only have a share of "future" profits.