Equity for Early Team-Members (Legal Crash Course for Entrepreneurs, pt. 6)

Hello Reader,

By now, if you’ve been keeping up with this series, you’ve probably covered the heavy stuff—leaving your comfy 9-to-5, setting up your startup, and figuring out how to divvy up ownership. (And hey, if you’re just jumping in now, don’t stress. You can always catch up on Parts 1 through 4 before you dive in here!)

But today, we’re going to talk about  the next big step  for your business: distributing equity to your team.  is one of the most exciting (and sometimes confusing) parts of startup life. Let’s get you oriented. We’ll focus on corporations, since that is the most common entity type for businesses that plan to share equity with their team. (It can be done with an LLC too, though. Jump to the end for a quick look at that.)

So, grab a coffee, and get ready for a heaping scoop of equity compensation with a side of tax benefits. 

Lots of Words! Let’s Start With Equity, Shares, and Stock.

First, let’s establish a common vocab. Equity is a general term for a portion of ownership in a company. Equity in a corporation is called stock, a unit of which is often called a share. Getting shares is the most fundamental way to receive equity in a corporation. Founders typically take shares. Sometimes early team members receive them too. 

Restricted Stock

If you’re giving (or getting) shares, it’s probably in the form of restricted stock, sometimes referred to as Restricted Stock Units or RSUs. They’re restricted because they come with limitations on their transfer. The company wants/needs to keep a tight reign on portions of ownership, so that it can hopefully sell itself one day or go public. 

Tax Implications of Shares

Shares are considered something of value the moment you receive them, so there’s the potential to owe taxes. That’s why companies typically sell them to recipients and/or exchange for services or IP. 

You’ll inevitably hear about “83b.” That’s a special tax election that helps minimize the tax implications of shares received. 

Owners Vote

Shareholders are part owners, and as owners they get to vote. They also have a right to certain corporate information. It’s a big step to welcome someone inside that circle. 

You Can Opt for Options

Options are a way for you to give team members a piece of your company without immediate tax implications and without a vote. They’re not a real share of the company. They’re an opportunity to purchase shares at a set price later, hopefully when you know you can sell them for more right away. There are two main types of options.

Incentive Stock Options (ISOs): ISOs come with some sweet tax advantages if they’re structured right. They’re only available to w2 employees, and the company has to have a legitimate valuation to set the strike price, the price you get to buy the shares at later. There are also limits on their issuance.  

Non-Statutory Stock Options (NSOs): NSOs are like the Swiss Army knife of options. They can be offered to anyone. There is no limit like with ISOs and no requirement to be an employee. 

Here’s the trade-off. NSOs don’t get the same tax treatment as ISOs. Some of the increase in value of NSOs is taxed as ordinary income. Gains from ISOs, if everything is done right, are taxed as capital gains, which is roughly half of the income tax rate.  

Vesting

So, what is vesting and why is it such a big deal? It’s the process by which your team members earn the right to fully own the shares you promised them over time. But why do it this way? Well, you want to attract people, but you also want them to stay, so you dole it out over time, usually based on continuous service. Although it can be based on performance if you want. This helps ensure that your investment in your team translates into them investing their time and effort in your company. It also protects you—if someone bails early, they don’t walk away with all their equity.

For example, you might offer your early team members 100 shares, but they won’t own all of them right off the bat. Instead, those shares will vest over 4 years, with a 1-year cliff. So, after a year, they’ll own 25% of their shares, and the rest will unlock a little at a time over the next three years. 

So Why Should You Offer Equity?

Why go through all this? Well, for a startup, cash can be tight. You might not have the budget to pay someone their full market salary, but equity allows you to offer something of value in the long run. You’re inviting your team to grow with the company. They’re not just getting paid to work for you—they’re getting a chance to own a piece of your startup’s future success. And that’s powerful.

Denouemont: LLC Equity

LLCs don’t have a reputation for being vehicles for distributing equity to your team, but you can totally do it. Equity in an LLC is typically known as membership interest. Kind of like shares, membership interest is something of value the moment you receive it, so it comes with tax implications. You also get a vote. 

Profits interests in an LLC function similarly to stock options. They start with a baseline value, and their potential growth is tied to the company's performance. Taxes are typically deferred until you receive an actual payout. Whether profits interests include voting rights or not depends on the specific terms set by the company.

Wrapping It Up

Equity is a fantastic way to attract and retain talent while investing your cash back into the company, but they come with plenty of legal complexity. If you’re feeling a bit overwhelmed by all the legal and financial details, don’t worry—you’re not alone. There are plenty of resources (including expert advisors) to help you navigate the waters. And of course, if you need some extra guidance, feel free to reach out. We’re here to help!

Until next time, keep hustling, keep growing, and remember: your startup’s success isn’t just about you—it’s about the incredible team you build along the way.