Sharing the Pie: Restricted Stock and Stock

Options for Employees#startupequity

Annie WebberFounder and CEOLegalHero

David EhrenbergFounder and CEOEGFS

Warning: a lawyerly thing to say

The information contained in this presentation is intended to serve as general background information on legal matters relating to starting a

business. The included information does not establish an attorney-client relationship between you and Legal Hero or Early Growth

Financial Services and is not a substitute for legal advice. Prior to taking any action, we encourage you to contact a lawyer.

What we’ll cover today

1. Issuing Equity: Why to share the pie

2. Overview of equity grant types

3. Stock Options vs. Restricted Stock vs. RSUs

4. 83(b) Elections

5. NSOs vs. ISOs

6. Structuring considerations

7. Valuation

Issuing Equity: Why to share the pie with employees

Attract Talent Retain Talent

Align Incentives

In the startup context, nothing matters more than attracting and retaining the right people to establish and grow your business, and you want them laser-focused on

that growth.

Overview of Equity Grants

Stock Options The right to purchase shares in the future at a price specified on the date of the grant

Restricted Stock Shares granted subject to certain restrictions

Restricted Stock Units Units that represent the right to receive shares, subject to certain restrictions

Stock Appreciation Rights Bonus plan that grants the right to receive cash or stock based on the increase in the value of stock over a period of time.

Phantom Stock Plan Bonus plan that grants the right to receive cash or stock based on the value of shares, to be paid out at the end of a certain period.

Options vs. Restricted Stock vs. RSUs

Stock Options

The right to purchase shares in the future at a price specified on the date of the grant

Restricted Stock

Shares granted subject to certain restrictions

Restricted Stock Units

Units giving the right to receive shares, subject to certain restrictions

What is it?

Value

Payment

Voting Rights/Dividends

Tax

Mostlyseen in…

Why?

Depends on increase above exercise price

Depends on stock price at vesting

Depends on stock price at vesting

Payment of exercise price No payment to receive shares No payment to receive shares

Upon exercise Yes, even during vesting period No, but co can choose to give div-equivalent bonus

Taxable at exercise for NSOs & ISO’s (AMT) and at share sale for ISOs

Taxable at vesting (unless 83(b) is filed)

Taxable at vesting

Early stage, high-growth startups

Co-founder arrangements More mature companies/later stage startups, esp those with liquid stock

Significant upside as valuation rises; ability to time taxation for employees

Value of company close to nil when stock distributed, so lower downside risk

Taxes due at vesting, but more mature stock sale can support payment required

IRC section §83(b): What you need to know

• Letter you send to IRS to inform that you’d like to be taxed on your equity on the date of equity grant rather than date equity vests

• Filing must be within 30 days after date of restricted stock grant and must be attached to tax return

• Section 83(b) elections are applicable only for stock subject to vesting

• Filing 83(b) advantages: o Can save you moneyo Help you avoid tax hit from vesting stocko Gets you long-term capital gains rate (if shares are sold more than a year after

exercise and 2 years from date of grant)

• Consult with your tax consultant!

If restricted stock is nominal, you should file 83(b). If your restricted stock is worth larger amounts, filing an 83(b) may trigger a big tax bill.

Stock Options: NSOs vs ISO

Difference lies in tax implications.

In general...better to have ISO:

• More flexibility with tax strategy• Lower tax burden• When exercising options, stock owner doesn’t have to pay

ordinary income tax on difference between exercise price and FMV of issued shares.

ISO = Incentive Stock Option NSO = Non-Qualified Stock Option

Structuring equity: What is vesting and how does it work?

What is vesting? The process by which a grantee accrues non-forfeitable rights over equity. The “Schedule”: the total time period over which the equity is to vest in installments (i.e. quarterly over 3 years, or monthly over 4 years)

The “Cliff”: the time period that must pass before any of the founder’s stock vests.

4 year schedule (monthly), with a one year cliff

So what’s market for employees?

Vesting protects companies from founders and employees that leave early.

Structuring equity: Other considerations

Transfer restrictions

Right of first refusal (ROFR)

Repurchase rights

Accelerated vesting

What it does

Why people care

Determines when stock may be sold or otherwise transferred

Gives company right to buy stock that’s being transferred

Gives company right to buy back stock

Accelerates vesting upon certain events, like acquisition or fired without cause

Co-founders don’t want to share company with strangers

Stockholders don’t want to share company with unknown parties

Company may want to control who can hold onto stock

Co-founders and employees want to realize full economic benefits

How it works Holder can’t transfer stock except for in certain enumerated cases

Company has dibs on matching price and buying stock that otherwise will be transferred to third party

Company can buy back stock at specified prices (usually FMV for vested stock, unless terminated for cause) and at cost for unvested stock)

Upon certain events, all unvested stock becomes fully vested (either single or double “trigger”)

Termination Provision

Unvested stock and options automatically forfeited; vested options subject to adjusted expiration

When employment ceases, vesting discontinues; depending on circumstances of exit, expiration date is adjusted

Company stock should be held by current employees contributing toward growth

What is a 409a valuation

• IRS requires Fair Market Value (FMV) analysis in conjunction with stock option grants

• Why? To ensure that federal income taxes are paid on stock issued as a part of deferred compensation plans

• Valuation must be performed by “qualified individual”

• If you plan on selling your business or raising capital, investors and acquirers will request an audit

What impacts your 409a valuation?

Company milestones

IP

The industry’s competitive dynamics

Strategic partnerships

Your investor base

The quality of your management team

When do you need a 409a valuation?

• Significant business event • Material change in company value• Prior to issuing stock options or other equity• Annual renewal (every 12 months)• External request from Board, investors, etc.

Keep in mind service provider requirements – don’t wait until the last minute!

The 409a valuation process – due diligence process

• GAAP Financial Statements• Capitalization Table • Articles of Incorporation• Option Schedule• Warrant Agreements • Debt Agreements• Balance Sheets • Income Statement• Financial Projections• Old Valuation Reports • Business Presentation

Thank you!

Questions?

Annie Webberannie@legalhero.comwww.legalhero.com@legalheroinc

David Ehrenbergcontact@earlygrowthfinancialservices.comwww.earlygrowthfinancialservices.com415.234.3437Follow us @EarlyGrowthFS