Freelancing for Equity Part 2: Receiving C-Corp Equity
Welcome back for the second blog installment of Freelancing for Equity on Loom!
As we discussed with Jose in our prior post, C-Corporations are the most common type of corporate entity structure for high-growth technology companies. And the most common types of equity that C-Corps issue as compensation are shares of common stock, and options exercisable for common stock.
The core difference between a share of common stock v. an option exercisable for a share of common stock is that the former means you own a part of the company, and have voting rights for that ownership. Options, however, are a right to own a part of the company, but until an option is exercised you do not own stock yet, and therefore cannot vote.
Thanks for sitting down with us again, Jose. Getting right into it, why are taxes such a critical part of understanding in C-Corporations?
Typically under IRS rules, if you receive something of value for services (including equity) without handing over cash for it, that is compensation, and it gets taxed like compensation; just like your paycheck. If you pay the “fair market value” (a complicated term, but just think of it as a technical meaning of ‘what it’s worth’) of something, however, you bought it, and it’s therefore not taxed as compensation.
Getting taxed for cash compensation is usually OK, because you can pay the taxes with the cash you were paid. Getting taxed for equity compensation, however, is much worse: because you got stock, but the IRS only accepts cash. Hopefully your stock will be worth a lot more in the future, but paying taxes for your stock means you’re “in the red” on Day 1.
So in the early days of a company, are you more likely to get stock or options?
In the very early days of a tech company, outsiders may be issued shares of stock for their services. The reason being that when a company is very young, the “fair market value” (FMV) of the shares is not very high, and therefore the tax consequences of receiving the stock for services (compensation tax) are relatively minimal. In the early days, if a Company issues options, even though stock is a possibility, it’s because they prefer not to give voting rights early on. Options ensure that you can’t vote until you earn (and then exercise) the stock.
Got it. Then later in the life of the company, you’re more likely to get options, right?
Correct. As a company hits either fundraising or business milestones, the FMV of its common stock starts to go up. As FMV goes up, that means that the tax consequences of receiving shares of common stock without paying for them (as compensation) become much more significant. To avoid handing service providers a tax bill along with their shares, companies will switch to issuing options exclusively.
Under tax rules that are too complicated to get deeply into, the most important thing to understand is that the receipt of an option is not taxable as long as the exercise price of the option equals the FMV of the underlying stock on the date of grant. So if the FMV is $1 per share, if I receive an option for 1,000 shares with an exercise price of $1 per share, I can receive that option without paying any tax on Day 1.
Obviously, most people would prefer to receive an option without paying taxes v. receiving stock but having to hand the IRS cash for taxes. That’s why options are a tax-efficient way to compensate service providers.
I’ve heard people talk about “NSO” and “NQSOs” — What are those and who should know about them?
The most common type of option granted to non-employees of a company is typically called a Nonqualified Stock Option (NSO or NQSO). The most important thing for you to understand about NSOs is that while you do not pay tax for receiving them, on the day you exercise them you will owe tax on the spread between the exercise price and the FMV of the stock on the date you exercise. The longer you wait to exercise, the larger the potential tax bill (if the stock has continued increasing in value).
Okay. So we have the different types of stock and options down, and their tax implications. What advice do you have for someone to understand how much of a company they have ownership of?
While taxes are something you should definitely be concerned about when receiving equity in a company, a more fundamental question is: how much of the company am I actually getting? Whatever you do, do not be dazzled by lots of zeros on the number of shares you receive.
Receiving a grant for 100 shares in Company A seems like a worse deal than receiving 10,000 shares of Company B, but when it comes to equity in companies, %s are everything. If Company A has a total of 200 shares outstanding, your 100 shares equal 50% of the company. But if Company B has 1 million shares outstanding, your 10,000 shares only got you 1%. Obviously understanding the total capitalization of the company issuing equity is massively important.
But capitalization (the term for the total size of the pie) comes in largely 2 flavors: outstanding and fully diluted. The main difference is that fully diluted includes the company’s ‘reserved’ but unused equity incentive plan, meaning shares it intends to use likely over the next 12 months, but hasn’t yet. Fully diluted is a larger number, and therefore your fully diluted % will be smaller (but more accurate long-term) than the outstanding %. You should ask what the “fully diluted %” of your equity is.
Great to know. One last question: People receiving equity in a company can be given it all at once, or earned over a specified amount of time. What is that called, and what do people need to know about it?
Right — one other material aspect of your issued equity will be your “vesting schedule,” which is a way for the company to have you ‘earn’ your equity over time, even if you get the full grant up-front. For options, a vesting schedule usually tracks the exercisability of your option. So if you vested in 1/4th of your option shares over your first year, you can exercise 1/4th of them.
Vesting schedules usually vary in length between 6 months to 4 years, depending on the length of an engagement. Monthly vesting is the most common, so if your vesting schedule is 6 months, you’d vest 1/6th of your shares each month. However, companies sometimes ask for a “cliff” on your vesting schedule, which means a kind of ‘trial period,’ through which you don’t vest anything until you hit the full cliff. So if your 6-month vesting schedule has a 2-month cliff, you vest in nothing after 1 month, 2/6ths (1/3th) after 2 months (the cliff), and then 1/6th each remaining month.
Vesting schedules for stock have similar terms, although they are implemented slightly differently. An option typically vests and then you can exercise and buy the stock. For a stock grant, however, you already own the stock on Day 1. Instead, a vesting schedule is implemented via a “repurchase right,” held by the Company. As your stock vests, that repurchase right goes away, ensuring that you own the stock fully.
So, to summarize:
(1) Understand the difference between Stock and Options, and the tax consequences of what you’re getting.
(2) Make sure you ask what the “fully diluted %” is of your shares or options, because that really tells you what % of the Company you are getting. Share numbers alone are meaningless.
(3) Pay attention to your vesting schedule, and any cliffs, because they determine how long it will take for you to fully ‘earn’ your equity.
That’s exactly what we were looking for — Thank you, José! Read more about these topics and continue to educate yourself on startups and venture companies at José’s blog, The Silicon Hills Lawyer and bring your projects to life with top design, development, writing and more freelancer talent at Loom.co
About José Ancer: José is a technology-focused corporate and securities partner at Miller, Egan, Molter & Nelson LLP, representing leading startups and emerging companies throughout Texas and various other tech ecosystems across the country. His legal practice focuses on formation, angel and venture capital financings, acquisitions, complex commercial and corporate transactions, and general advisory regarding corporate and financing strategy. While attending Harvard Law School, he was awarded Dean’s Scholar Prizes in Securities Regulation, Startup Company Law & Finance, and Business Strategy.
Additional note: this blog post does not constitute as legal advice and we recommend that you always seek the advice of a licensed lawyer to advise you on your specific situation to plan and protect yourself.
