NonQualified/NonStatutory Stock Options v. Restricted Stock for Early Independent Contractors

Many of our pre-funded startup clients have hired us to form their business entities, and are beginning to onboard a few early hires at this time.  For most of our clients, the status of the early hire is that of an independent contractor, often called a “consultant.”  In this blog post, the ladies of Smith Shapourian Mignano LLP provide a brief explanation as to stock compensation for these independent contractors, a commonly asked question.

1.    What Types of Stock-Based Plans are Available?

There are two types of stock-based plans: (1) nonqualified plans; and (2) qualified plans (i.e., plans providing for incentive stock options (“ISOs”) or employee stock options).  Independent contractors or employees may be granted nonqualified/nonstatutory stock options (“NSOs”).  Conversely, ISOs may only be granted to employees, not independent contractors.  

For the sake of this blog post, we focus on NSOs as most early stage hires are independent contractors.

2.     NSOs

A startup may decide on a non-qualified stock plan for key early hires, as this is generally aimed at retaining key personnel.  Further, because a non-qualified stock option plan is not subject to special statutory requirements, it has greater flexibility in the way in which stock may be made available.  Unlike ISOs, NSOs may be offered to a select group, may be granted to different groups on varying terms, may be offered for substantially less than market price, and may be exercised at any time.  

I.R.C. § 83 generally applies any time property is transferred, in connection with services, to any person other than the person for whom the services are performed (usually, the employer.  It does not apply to ISOs, employee stock purchase plans, or the transfer and exercise of certain stock options.  Notably, however, it does apply to NSOs, and for that reason, § 83b election forms generally accompany nonqualified/nonstatutory stock option agreements provided to these early hires.

If the hire makes an election under I.R.C. § 83(b), the hire will be taxed in the year the property is transferred.  Thus, if the current price of the stock is low and it is likely to appreciate substantially in value, the hire may make this election at the outset to avoid having to pay tax on the property’s appreciation at the time the property is transferred in the future.

3.    Restricted Stock

Restricted stock is company stock that is subject to conditions which must be met before the sale or transfer of the stock.  Restricted Stock Units (RSUs) are equivalent to shares, but are converted to stock upon vesting.  
Generally, Restricted Stock Shares (RSS) and Units vest in increments over a period of time (usually four years), or when performance goals are met.  Conversely, stock options (i.e., NSOs in this example) do not automatically vest like restricted stock.  Rather, they are subject to an expiration date, and the hire may only exercise them during a specific timeframe.

As with NSOs, I.R.C. § 83 applies to grants of restricted stock, and so the restricted stock agreement is generally accompanied by a § 83b form.

4.    Which to Issue to Early Hires?

In many cases where the startup was formed but where was no simultaneous equity investment, and the number of early hires (i.e., independent contractors or consultants for the sake of this example) is relatively small; it may behoove the startup to issue restricted stock rather than stock options for a variety of reasons.  

One of the most important reasons is cost.  IRS Regulation 409a valuations are necessary to set the strike price of NSOs, but are often costly.  By issuing restricted stock as opposed to NSOs to its independent contractors, the startup will not have to pay for an 409a valuation.  Rather, the Board of Directors can simply set the fair market value of the restricted stock as the par value since, at this pre-funded and just-formed stage in the company’s lifecycle, the company does not have much value.  

Another important reason is attractiveness to early hires.  For early hires, options can become worthless if the strike price turns out to be less than the fair market value, or if not exercised during the specified timeframe.  By contrast, early hires will always retain restricted stock, and will not have to worry about fluctuation in value.  

Smith Shapourian & Mignano, LLP is available to answer any questions or concerns you may have regarding compensating your early stage hires.  Please contact us for a consultation.

This blog does not constitute solicitation or provision of legal advice, and does not establish an attorney-client relationship. This blog should not be used as a substitute for obtaining legal advice from an attorney licensed or authorized to practice in your jurisdiction. You should always consult a suitably qualified attorney regarding any specific legal problem or matter in a timely manner, as statutes of limitations may bar your claim.