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Stock is Great – but Don’t Give It Away Too Quickly!

Most startups and early-stage companies have limited cash. As a result, they often are eager to use stock as a major component of? compensation. They need to make sure, however, that personnel stick around long enough to make the contributions for which they are being compensated.

In some instances, the corporation creates a tax-qualified incentive stock option plan. Employees are granted options to purchase stock, and they do not have to pay any tax on the stock (actually, on profits from their sale of the stock) until they exercise the option (purchase the stock, presumably, at a low price) and, later, sell the stock. (Tax law is less favorable to independent contractors.)

A prudent company will make sure that the options are subject to vesting – the longer the employee stays on board, the greater the number of shares s/he gains the right to purchase. For example, options on one-fourth of the shares? might vest after one year, with 1/48 of the total vesting each month thereafter, so that the entire option grant is vested after four years. (I am, though at this point probably should not be, surprised when employees of a company tell me that they were not aware that options typically are subject to vesting.)

In another scenario, founders or key executives might be granted stock, rather than options, for business and tax reasons. To keep these personnel around, the shares are subject to reverse vesting, i.e., the company’s right to buy the shares back, at a low price and in diminishing amounts, over time. So, as the mirror image of the preceding example, the company could have the right to buy back all of the shares during the first year, at the end of which only three-fourths could be bought back. Thereafter, the amount subject to buy-back is reduced by 1/48 of the total each month, so that after four years the reverse vesting is complete.

The essential point: Stock is valuable. If you are going to give some of it away as compensation, use vesting or reverse vesting to make sure that the personnel you are compensating earn their compensation.

Related Post: Rewarding Key Personnel: Restricted Stock or Options?

Dana H. Shultz, Attorney at Law +1 510-547-0545 dana [at] danashultz [dot] com
This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact a lawyer directly.