How Taxes Are the Elephant in the Room for Equity Compensation

Tax liabilities often dictate the form of equity compensation startups give to their founders/managers and key employees. In general, companies have two options for equity compensation: stock options and stock grants. As a rule of thumb, startups tend to select the former of those options.

Often it is tax considerations driving this choice — grants are taxable upon grant if fully vested (or pursuant to a Section 83(b) election), which if the grant is compensation the tax must be withheld from or otherwise paid by the recipient. On the other hand, with stock options the option is not taxable (if priced at fair market value on the date of the grant of the option) to the recipient until the grant is exercised, and because stock options are generally exercised to take advantage of either liquidity events or spikes in the stock price and therefore the stock is sold upon the exercise of the option, which gives the recipient the cash to pay the tax.