Life science startups in the United States looking to lure new talent may be strapped for cash, but stock-based awards may be just the ticket to creating competitive employee compensation packages.
Jake Ornstein, JD, a partner with Orrick, Herrington & Sutcliffe LLP 's global Technology Companies Group, shared with Cure the pros and cons of issuing five types of equity that early-stage companies might use to award to founders, employees, and external partners. These options help companies compete for the talent critical to successful growth.
1. Incentive stock options (ISOs):
These awards can only be granted to employees who would have the option of buying a certain number of company shares at a set price after a vesting period ends[P(1] . One major advantage of ISOs is that they are taxed at the capital gains rate—not as income.
That said, ISOs do present some challenges to the companies granting them. Notably, the company must complete a 409a valuation to determine the fair market value of its stock. This valuation helps determine the exercise price, or “strike price,” for the options, which must be equal to or greater than fair market value.
Also, it’s important to keep in mind that the U.S. tax code states employees cannot receive ISOs worth more than $100,000 in any calendar year. So, if a company starts to grow rapidly, it may face limits to how it can use this benefit to attract new talent.[P(2]
2. Non-qualified stock options (NSOs):
These options offer more flexibility than ISOs because they can be awarded to both employees and non-employees, such as outside consultants. However, when NSOs are exercised, the difference between the strike price and fair market value is taxed as regular income tax. So, NSOs may not be as attractive to new hires as ISOs.[P(3]
3. Founders preferred stock:
Also known as FF or “starter” stock, this special class of stock is an early path to liquidity for founders. That’s because theycan be converted into any series of preferred stock when sold to investors in connection with a future round of financing.
Founders preferred stock has the same rights as common stock and, like ISOs, allows founders to pay capital gains tax instead of ordinary income tax when they sell their shares. Also, startups that transfer common stock to their investors can pull up the value of that stock for 409a valuation purposes. In contrast, founders preferred stock can be set up with guardrails that will put less pressure on the 409a valuation.
4. Phantom stock:
This is an employee benefit plan that’s also known as “shadow stock.” Employees who receive phantom stock don’t receive shares in the company. Instead, they receive mock shares that match the company’s stock price.
Phantom stock can be issued as “appreciation-only” shares that pay out the amount of the increase in the company’s stock value over a defined period. Or they can be “full value” plans that pay appreciation plus the value of the underlying stock. One big advantage for startups is that issuing phantom stock won’t dilute the company’s ownership structure. The main disadvantage for employees is that the payouts count as income at tax time.
5. Restricted stock units (RSUs):
Similar to phantom stock, RSUs are not actual shares of stock. Rather, RSUs represent the right to receive common stock at a later date. RSUs can be awarded with either time-based vesting or milestone-based vesting tied to a specific event, such as an initial public offering or merger. Because of their complicated structure, RSUs may be best suited to late-stage startups that have historically granted ISOs but are limited from issuing more because of the company’s rising valuation and strike price.