A Potential Silver Lining to Lower Covid Valuations: Equity Grants

Covid sucks, but for the sake of optimism, here's something to consider.

Lower business valuations make equity grants more feasible and advantageous from a tax standpoint.

Here's how.

Equity granted in exchange for services is taxable based on the fair market value of the shares or LLC interests.

So if your business is valued at $5 million, and you grant 10% in equity to a new team member, that team member will have to report $500,000 in ordinary income on their tax return and fork over roughly $200,000 in cold hard cash to pay income taxes.

On top of that, the company will owe employment taxes on the grant value.

It's an unfortunate tax rule that promotes inequity, and there is grumbling to change it. But for now, it’s the law of the land.

Stock options and LLC "profits interests" solve the tax issue — but at significant expense to the recipient of equity.

In example above, the recipient would receive options rather than stock and would then have to pay a $500,000 "exercise price" to buy the shares they've been granted.

Of course, option recipients will not exercise until the company's stock has appreciated, typically in connection with an exit. But in the meantime, the capital gains tax clock is not running and they have none of the rights of a stockholder. And if the recipient leaves prior to a liquidity event, they need to somehow come up with the exercise price (often within 90 days) or risk forfeiting their options.

LLC profits interests have fewer of these drawbacks but the recipient still must forego $500,000 in value to avoid taxation upon grant. Again, not ideal.

When a company's valuation is low, stock and LLC interests can be granted with reduced tax and other burdens. Equity recipients have the potential to retain more of the benefit of the equity grant, enhancing both the economic value and incentivizing impact of the grant.

So bottom line - if you have been considering equity grants, now might be a good time to make it happen. A revised company valuation for equity grant purposes can be done quite cheaply these days, and having a fully-incentivized team in place as we turn the Covid corner might make a big difference.