Source: Unsplash
TLDR
- To reward employees early on, startup founders have several options for granting ownership in their startups.
- Two types of vehicles used to grant ownership include RSUs and ESOPs. RSUs (or restricted stock units) incentivize your employees to stay with your startup, helping it perform at its best. ESOPs, or employee stock ownership plans, give employees ownership in the startup, benefitting them financially and increasing their loyalty to the startup.
- RSUs, or restricted stock units, are “unsecured, unfunded promises to pay cash or stock in the future and are considered nonqualified deferred compensation,” subject to the Internal Revenue Code. Typically, one RSU represents one stock share. These stock units are generally not taxable when granted; however, they are taxed once the restricted stock units vest. Vesting is a process where the employees become entitled to the granted stock over a period of time, such as three years.
- An ESOP is a qualified defined contribution plan governed by the Internal Revenue Code (IRC) and the Department of Labor (DOL). These plans are stock bonus plans explicitly designed to invest in qualifying employer securities, such as your startup’s stock.
- According to the National Center for Employee Ownership (NCEO), ESOPs are the most popular form of employee ownership in the U.S., with 6,500 companies having an ESOP, thus allowing 14 million U.S. employees to participate in an ESOP.
- Regardless of the differences between RSUs and ESOPs, offering stock ownership to your employees is highly beneficial to both your team and your startup. With actual employee ownership, you can create a culture of dedicated, happy, productive employees, all directly contributing to the success of your startup.
To reward employees early on, startup founders have several options for granting ownership in their startups. However, when you start digging into the options, it seems more like alphabet soup than compensation and ownership structures.
Two types of vehicles used to grant ownership include RSUs and ESOPs. RSUs (or restricted stock units) incentivize your employees to stay with your startup, helping it perform at its best. RSUs also permit you – as the founder – to defer issuing any startup shares until restrictions and vesting are met. This deferral helps you delay any share dilution.
ESOPs, or employee stock ownership plans, give employees ownership in the startup, benefitting them financially and increasing their loyalty to the startup. Like RSUs, ESOPs give employees a vested interest in your startup not only doing well but excelling.
When employees have a vested interest in your startup, they are often more engaged and willing to promote its culture and values. They also are interested in the company performing above-board, as it directly benefits them. This alone bodes well for your attraction and retention of top talent along with the overall success of your startup.
Despite similar purposes, RSUs and ESOPs are different employee compensation structures. In this article, we’ll break down the differences between RSUs and ESOPs as well as their benefits.
What Are RSUs?
RSUs, or restricted stock units, are “unsecured, unfunded promises to pay cash or stock in the future and are considered nonqualified deferred compensation,” subject to the Internal Revenue Code.
Typically, one RSU represents one stock share. These stock units are generally not taxable when granted; however, they are taxed once the restricted stock units vest. Vesting is a process where the employees become entitled to the granted stock over a period of time, such as three years.
Upon vesting, RSUs are assigned a fair market value. The Internal Revenue Service considers RSUs fully taxable upon vesting. After a portion of the stock shares is withheld to pay taxes, the employee receives the balance of the shares and may sell them at their discretion.
Restricted stock units do not carry shareholder voting rights. Employees holding RSUs may vote on startup matters once the restrictions on the shares lapse and the RSUs are converted into common shares. Additionally, once vested, employees can receive dividends as well.
The Tax Benefits of RSUs
RSUs enjoy favorable tax treatment. Here are some key benefits for both the startup and its employees:
- Taxed Upon Vesting. With RSUs, the stock units aren’t taxed until vesting, not upon grant. The taxable amount is the market value of the shares at vesting. This taxable amount is considered compensation for federal and employment taxes and any state and local taxes.
- Capital Gains Treatment. Once vested, if the employee sells the shares, they will pay capital gains tax on any appreciation over the market value of the shares on the date of vesting.
What is an ESOP?
Adding to the alphabet soup is the ESOP. An ESOP is a qualified defined contribution plan governed by the Internal Revenue Code (IRC) and the Department of Labor (DOL). These plans are stock bonus plans explicitly designed to invest in qualifying employer securities, such as your startup’s stock.
According to the National Center for Employee Ownership (NCEO), ESOPs are the most popular form of employee ownership in the U.S., with 6,500 companies having an ESOP, thus allowing 14 million U.S. employees to participate in an ESOP.
In an ESOP, an employer-sponsored benefit plan is set up with a trust, similar to other retirement plans like a 401(k). However, unlike a 401(k), tax-deductible contributions are solely invested in company stock. The law permits ESOPs to hold 100 percent of your startup’s stock or any percentage less than 100 percent.
Eligible employees who participate in the ESOP are called participants, and they accrue shares of company stock over time. ESOP participants are entitled to both voting rights and dividend payments.
In ESOPs, the trustee is the shareholder. So, under law, the trustee must vote the shares of the plan as a fiduciary duty when such as vote is required. However, the law requires the ESOP trustee to “pass-thru” votes to the individual ESOP participants, such as in the event of a merger, dissolution, liquidation, recapitalization, reclassification, or sale of substantially all the startup’s assets.
Once a participant leaves the company, the company buys back the shares, giving the participants cash for the value of the shares. At that time, the employee is then taxed on the value of the stock.
Since ESOPs are part of employees’ compensation packages, these defined contribution plans can help keep employees motivated and loyal – as ownership often helps employees focus on the startup’s performance. And rightly so. The better the company performs, the higher the value of the stock. And the employees directly benefit.
ESOPs and Corporate Transactions
In addition to granting employee ownership, ESOPs can also be used when founders are ready to sell their business. For example, an ESOP “can buy a departing owner’s shares in pre-tax dollars on terms that are highly favorable to the owner, the employees, and the business itself. Selling owners can sell any portion of their stock to the ESOP, and they can defer tax on the gain from the sale if certain requirements are met.”
By using ESOPs in corporate transactions, such as those providing an exit strategy for the founder, the ESOP provides liquidity to the founder and favorable tax consequences for the founder. The departing founder can choose to sell all or some of their shares, providing for leadership succession, continuity of the startup’s culture, and a diverse wealth strategy for the founder.
The Tax Benefits of an ESOP
ESOPs enjoy favorable tax treatment. Here are some key benefits for both the startup and its employees:
- Tax-Deductible Contributions. Employer contributions of stock and cash are tax-deductible when they’re made. While this helps the founder’s cash flow, it also dilutes the current ownership of employees if new shares are issued. For cash contributions, this deduction is available whether the founder decides to use the cash to buy shares of stock for participants or to create a cash reserve within the ESOP.
- Tax-Deductible Loan Contributions. ESOPs can borrow money to purchase new or existing shares of stock. The employer still receives a tax deduction for the contributions to the plan, regardless of their source. This means that “ESOP financing is done with pre-tax dollars.”
- Tax-Deductible Dividends. For any reasonable dividends used to repay a loan against the ESOP, passed through to participants, or reinvested by participants into company stock, those dividends are also deductible.
- Tax-Favorability for Employees. ESOP participants don’t pay taxes on contributions to the plan. They are only taxed when they take a distribution from the plan. When participants take a distribution, they can roll over their ESOP assets to another qualified retirement plan or an individual retirement account (IRA). If they choose to take a cash distribution, the participants will pay regular tax rates on the allotment but capital gains on any earnings. However, if distributions are made early, such as before the normal retirement age, the participant will face an additional 10 percent penalty on the amount distributed.
- Tax-Deferral for Sellers of a C-Corporation Startup. For c-corporations, “once the ESOP owns 30% of all the shares in the company, the seller can reinvest the proceeds of the sale in the company, the seller can reinvest the proceeds of the sale in other securities and defer any tax on the gain.”
- No Tax on Ownership for S-Corporations. In s-corporations, “the percentage of ownership held by the ESOP is not subject to income tax at the federal level (and usually the state level as well): That means, for instance, that there is no income tax on 30% of the profits of an S corporation with an ESOP holding 30% of the stock, and no income tax at all on the profits of an S corporation wholly owned by its ESOP. Note, however, that the ESOP still must get a pro-rata share of any distributions the company makes to owners.”
How Do RSUs and ESOPs Compare?
Source: Equivista
Regardless of the differences between RSUs and ESOPs, offering stock ownership to your employees is highly beneficial to both your team and your startup. With actual employee ownership, you can create a culture of dedicated, happy, productive employees, all directly contributing to the success of your startup.
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