7 equity mistakes to avoid as an early stage company in the US

Equity can be one of the most powerful tools for attracting and retaining talent in the early days of your startup. But managing it correctly is far from simple. From IRS deadlines to board approvals, even small oversights can create big financial and legal headaches — for both founders and employees.

In this guide, we’ll walk through the most common equity mistakes early-stage US companies make, and share how to avoid them so you can keep your team motivated, your business compliant, and your growth on track.

What are the most common mistakes?

Here are some of the most common mistakes early-stage startups make when managing equity:

1. Not filing an 83(b) election as a founder

83(b) elections are counterintuitive. After all, you’re asking the Internal Revenue Service (IRS) to tax you on all shares; even the unvested ones. And why would you want to accelerate tax?

Well, if your company has just been incorporated, your stock is likely to have a very low value. So if you acquire that stock by paying a low fair market value (FMV) and file your 83(b) election on the unvested stock, then your ordinary income taxation — the federal tax that normally applies to salary and other employee compensation — will be zero.

By requesting to be taxed on the value of all stock (including stock subject to vesting), you can avoid being taxed later once the stock vests (and has a potentially higher valuation).

To do this, you need to file an election to the right IRS office within 30 days of the date on which the common stock is transferred to you. If you fail to do this (or miss the deadline), there’s no easy fix — at least not without tax risk). So be careful.

2. Not requesting a 409A valuation before granting options

Early stage companies are cash sensitive. And the last things you want to spend money on as a founder are legal and administrative tasks.

Why, then, would you spend money on a 409A valuation (to help set the exercise price of options), when you can simply make up a value?

Well, it’s a bad idea because of the tax implications that granting options at a discount can have on the company and your employees.

At your next round, investors may require a retroactive valuation. You would have to go back in time and show that the options were not granted at a discount. This can delay a funding (or merger and acquisition process), and your legal costs will go through the roof.

Options may have been granted at a discount, triggering some difficult consequences:

• Options you thought were ISOs will, in fact, be NSOs, because ISOs must have an exercise price equal to at least FMV as of the grant date.
• As the options vest, your employees will be considered as receiving a benefit equal to the difference between the exercise price and the FMV of the shares at vesting.
• There’s a penalty (and interest) at the federal, and sometimes state level, which will continue to accrue.
  
  

‍3. Forgetting to renew your 409A valuation

A 409A valuation is only valid for 12 months at most (provided that no event that materially affects the value of the company takes place in that period).

A lot can happen in 12 months, especially for companies doing well. Some companies will either forget that they need to request a new valuation after certain events happen, or consider that they can keep on granting options under an expired 409A valuation because nothing significant has happened in the life of the business.

Some companies will also rush to make new grants before the 409A expires, assuming the FMV will become higher with the new 409A valuation (resulting in a higher exercise price for their employees). In those circumstances, it can be difficult for companies to defend granting options at a value reflected in the existing 409A valuation, when a new 409A valuation indicates an important change in valuation as of a short period later.

4. Promising grants without a board approval

Every grant of equity award requires a decision from the board (or a committee, if it has been specifically set up by the company in accordance with the equity plan). There’s simply no shortcut you can take here.

In the board approval, you need to find all the required parameters of the grant, meaning:

• The person receiving the grant
• The maximum number of shares subject to the grant
• The class of shares (usually common stock)
• The minimum exercise price

If certain key terms such as vesting acceleration or early exercise have been negotiated, they should also be found in the board consent.

5. Stating a fixed exercise price in offer letters to candidates

The exercise price should be equal to (or greater than) the FMV of the shares on the grant date. If you want to attract a new candidate who wouldn’t start right away, it’s tempting to put the then-current fair market value in the offer package provided to this candidate.

However, you shouldn’t, because there is no certainty that the person will benefit from the exercise price stated in the offer letter, as the FMV of the stock may of course increase (or decrease) by the time the grant is made.

6. Granting equity to a candidate who hasn’t started yet

Sometimes companies want to be too quick and offer equity immediately. Under a typical equity plan, only service providers who are in service on the grant date can be granted equity. In practice, this means that you can’t grant equity until the candidate has officially joined the company as a service provider (whether it’s an employee, a contractor, or team member hired through an employer of record (EOR)).

7. Not approving an exercise request in time

Most companies use an equity platform like Carta. And when someone exercises on Carta, the fact that the employee asks to exercise doesn’t mean that the exercise is effective.

The company needs to approve the exercise on Carta, and it’s only then that the employee will be able to complete the exercise process and receive their stock. If your company waits so long that the option expires, or that the FMV increases (and therefore the tax due on the spread also increases), you will be in a bad situation vis-à-vis the employee.

How can Remote help?

As an early-stage startup, setting up and managing equity incentives for your team members may sound incredibly complex and off-putting, especially if you have team members in different locations.

But with the right provider, the entire process is clear and simple from start to finish, with full support and guidance at every step. Remote Equity handles everything for you, enabling you to take advantage of the many recruitment and retention benefits of equity incentives, and helping ensure you don’t make the same mistakes listed above.

To learn more, speak to one of our friendly equity experts today.