It’s a good time to revisit the very basics of cannabis company structuring, particularly in light of two new developments in 2018: tax reform and California state-wide legalization. Thus, this is the second article in our three-part “Reviewing Corporate Law Basics” series. The first post discussed cannabis entity selection. Today’s posts moves past the initial formation phase, and covers equity incentives for startups.
In the startup world, employee equity is as ubiquitous as the logo t-shirt, the bean bag chair, and the ping pong table. The potential upside employees perceive in their equity incentives brings the talent in and keeps them engaged: Employees are both incentivized to increase the value of the company and stay at the company through their equity vesting schedule. In theory, everybody wins.
Cannabis startups, particularly those developing technologies and building capital-intensive businesses to scale, will increasingly find the need to offer employee equity to stay competitive. In making the decision on what types of equity incentives to offer, companies must consider their growth path and the effect on future financing options, their employee base’s preferences, their own capacity to manage an equity incentive plan (or hiring experienced counsel to do so), and, most importantly, the tax consequences for the company and its employees.
This post cannot exhaustively cover each of the below structures, but will provide the key advantages and disadvantages, to inform the business owner (or employee) faced with the choice:
- Stock Options (ISOs and NSOs)
- Restricted Stock with an 83(b) Election
- Restricted Stock Units (RSUs)
- Something Else – Profit Share, Target Bonus, Performance Incentives
Stock Options come first because this type of equity incentive sits foremost in the public consciousness: Many company founders want a “stock option plan” before they consider what that entails. However, most founders that evaluate all of the potential forms for employee equity incentives eventually choose not to go with stock options. In the end, whether its Incentive Stock Options (ISOs) or Nonqualified Stock Options (NSOs), the calculus generally boils down to the plans being complicated and unpredictable.
On the company side, the plans are complicated because management must regularly run 409A valuations to determine strike prices, then track all of the exercise dates and received paperwork (and the company’s ever-fluctuating number of shareholders), and then calculate the proper tax withholding for all options exercised based on the delta to the stock’s fair market value set by the 409A valuation.
On the employee side, stock options are complicated because the employee must decide whether or not to exercise the the options, and then pay out-of-pocket if choosing to do so. Options are also unpredictable in that a downtown in the company’s value could result in “underwater options”– employees stuck with tax consequences but with no chance of selling stock to cover the tax bill. While these issues have some solutions to reduce the pain to the company (third-party administrators of option plans are recommended), and while the underwater options issues is rare-but-very real (ask those that lived through the tech bubble bursting in 2000), there’s no escaping that stock option plans inherently complicated and unpredictable, and thus make sense for a small percentage of startups.
Restricted Stock with an 83(b) Election
I use the “…with an 83(b) Election” qualifier when discussing Restricted Stock Plans with clients, because filing an 83(b) election is critical to making Restricted Stock Grant work in an employee’s favor – and it’s an election the company had better inform its employees of, as missing the filing deadline is a mistake that can’t be undone.
So what is a Section 83(b) Election? Simply stated, it’s a “tax election” the employee taxpayer makes with the IRS, under IRC Section 83(b). The election must made within 30 days of the grant of restricted stock (simply by filling out and mailing the IRS a form). The election informs the IRS that the taxpayer elects to realize income as of the grant date, rather than on the grant date. This can be particularly advantageous for very early-stage companies, that can credibly state the value of their shares is minimal. Then, any future gain in value recognized upon selling the stock would be capital gain or loss. Further, if shares are held for more than 12 months, the employee may get long-term capital gain treatment.
Restricted Stock may become more difficult for later-stage companies, because even with an 83(b) election, paying tax on fair market value may be prohibitive for some employees. However, a company that’s later stage and better capitalized may be in a better position to offer an employee a bonus to make up for the tax burden, or can look to switch equity plans now that the company has more resources. But for early-stage companies Restricted Stock with an 83(b) Election is the right choice 90% of the time. The “Restricted” part is to be discussed with your securities counsel – all stock will carry certain securities legends, will initially be subject to a company’s right of repurchase (which lapses over the course of a vesting schedule), as well as other transfer restrictions to prevent sale on public markets and preserve the company’s closely-held status.
Restricted Stock Units (RSUs)
An RSU award is essentially a contract to award stock at a later date, or award an employee cash as value for stock. RSUs are not stock, and because they are not property, an 83(b) Election is inapplicable. They have risen in popularity among later-stage tech companies, primarily at the expense of stock options, because they are significantly more straightforward (particularly from the employee’s perspective). They give the employee what employees want– the ability to receive “stock” without having to pay to exercise or purchase it. Then, upon meeting vesting requirements, the employee either receives their specified shares of common stock, or cash equal to the value of a their common stock.
Many companies had come to disfavor RSUs in recent times, though. Employees with RSUs are not putting in any purchase or exercise price, the 409A valuation requirements are amplified, and the company must pay employees cash upon each vesting milestone (because the 83(b) is not available). Thus, until recently, the RSU only made sense for large, cash-rich “startups” (which at that point, were full-blown companies). However, a new tax election created in the Tax Cuts and Jobs Act (“TCJA”) may make the RSU more feasible for certain companies and employees: The 83(i) election allows an employee that owns 1 percent or less of a company to delay realizing income until there’s an exit (or for up to 5 years), so long as the company has a plan in place that awards some equity to 80 percent or more of the total employees in the company.
Other Incentive Plans
While equity incentives may seem overly complicated, with a well-drafted Employee Equity Incentive Plan and competent counsel, companies can and do manage all of the structures listed above. So maybe you can, too…. but do you need to? Equity incentives work best for startup companies that are building towards an exit: an acquisition, a merger, a public offering. Often these companies want to conserve as much cash as possible, to devote to product development, and offering employee equity allows the company to compete with larger companies for top talent. However, if your company anticipates fewer costs on its runway to profitable liftoff, and is built to operate profitably, then perhaps your business needs another form of employee incentives– a profit share, a target bonus for profit or revenue, or other performance bonuses. Although these aren’t as sexy as the “stock options”–and you may miss out on a few potential employees that have stars in their eyes–crafting an incentive plan that fits your business will ultimately help you attract and retain the right type of talent.
Finally, one thing should be noted: Regardless of the equity incentive plan your cannabis company chooses, you can still get the logo shirts, bean bag chairs, and ping pong table.