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Start-up Employees: A Missed Opportunity?

By Holly SwanExecutive Director, Advisor Institute

If your growth strategy includes attracting and serving serial entrepreneurs, your prospective clients should also include their employees who receive incentive compensation.

While serial entrepreneurs are often supported by a team of advisors, employees of start-up companies are usually self-serve and may not see the value in working with an advisor, which provides an opportunity for you to demonstrate how you can add real value.

Many advisors are inclined to plan for these employees in the same way they plan for corporate executives. There are a couple key differences to note.

  • In a typical option arrangement, employees receive options that vest over a number of years. The options give them the right to buy the stock at a pre-determined strike price, which is generally the fair market value (FMV) of the stock at the time the options are issued. Because non-publicly traded stock doesn't have a daily market, and there is less transparency with respect to the company's value and future prospects, start-up employees are often confused about when to exercise their options.

  • Employees often wonder how they should exercise their options. With options in publicly traded stock, employees will sometimes have the ability to do a cashless exercise. Cashless exercises are more difficult for startups because there isn't a public market, making cash exercises necessary in many cases.

Asking start-up employees the following questions can help you illustrate your understanding of the additional complexity involved with their incentive compensation structure, particularly as it relates to options.

  • "What is the company's current share value?" Options are considered to be in the money when the current value of the shares is higher than the strike price, at which point employees should consider exercising vested options.

  • "Do you have the cash needed to exercise your options?" Cashless exercises are generally not an option, which means employees will need to have the cash on hand to exercise or may choose to wait until IPO to exercise when a cashless exercise will be easier to implement.

  • "What are the tax ramifications of exercise?" Non-qualified stock options (NQSOs) are taxed at exercise. The taxable amount is the discount the employee receives on the stock and is taxed as ordinary income. Incentive stock options (ISOs) are not taxed at exercise. They are taxed upon sale and the tax treatment varies, depending on the length of time between the sale date and the grant and exercise dates. Note that ISO exercise is an alternative minimum taxable (AMT) preference item. This means that the bargain element is generally includable in the calculation of AMT income in the year they're exercised.

Bottom line: Demonstrate your value with start-up employees by showcasing an understanding of their incentive compensation structure and your ability to help them navigate the options and opportunities available to them.