If you work at a startup company or have startup clients, you know all too well that cash can be tight and hiring and retaining top talent is a challenge.
In response many startups turn to equity compensation to attract and retain top talent without breaking the budget on salaries and benefits. Stock-based compensation also ties employees to the company's success as they essentially become owners. Employees will theoretically work harder and think twice before leaving if they have a chance to earn a substantial windfall in exchange for taking a below-market starting salary.
Great. But founders and their financial teams must remember that equity compensation is not free — it's a form of deferred compensation that must be treated as an expense. As such, equity compensation has strict rules and regulations for employers and employees to follow, especially regarding taxes.
Even with substantial financial backing, many private/early-stage companies do not have enough resources to handle complex GAAP accounting and financial reporting for SBC awards. This can be problematic since larger investors or banks typically want a third party to sign off on the accuracy of the startup's financials. They want assurances that the company is not doing anything fraudulent or failing to follow GAAP guidance. Also, being careless with SBC in your company's early years can make it very costly and time-consuming to change from non-GAAP to GAAP standards as you prepare for an IPO, sale or other exit.
Setting the table
One of the top requirements is to determine fair market value for the company's stock through a 409(a) valuation, which is required for tax compliance and necessary before optioning or issuing stocks. Typically, startups will need to undergo the 409(a) valuation once per year and any time after they raise funding. Companies should also provide reasonable guidance to employees about the tax consequences of various types of equity compensation. That's very important since some employees, particularly young workers, have never received equity compensation before. When restricted stock awards provide ownership interest upon vesting, the 83(b) election allows these awards to be taxed at the grant date based on their FMV — even if they have not fully vested. By making an irrevocable 83(b) election within 30 days of the RSA grant, employees recognize taxable income immediately without waiting for vesting. This strategy can be beneficial if the stock's value is expected to rise, since it minimizes ordinary income and maximizes capital gains upon sale. However, employees and their advisors should be cautious because taxes paid via this election are non-refundable if the RSA does not vest, or if its value declines. Generally, paying tax upfront is advantageous when the stock's value is lower.
Five things that founders and financial teams often overlook regarding equity compensation
1. Being too generous: Founders might want to understand various types of share-based payment awards, such as stock options, restricted stock awards, restricted stock units, etc., that best align with the company's expected growth and strategies. They might unintentionally give out too many shares in employee equity plans without taking into account long-term equity dilution. Without careful planning, founders could inadvertently allow employees to receive more financial benefits than the company planned for in a liquidity event. Also, the founders might not have enough shares to give up in later rounds of financing.
2. Vesting criteria too easy to meet: Share-based payment awards come with various vesting conditions, with a plain vanilla plan being a four-year service vesting requirement without other performance conditions or without taking market conditions into account. Founders and their financial teams may want to provide employees with additional conditions if the vesting conditions are easy to achieve. Otherwise, key employees might leave the company much sooner than expected. I've found over my career that the easier the vesting conditions, the less motivation employees tend to have to perform at a high level and attrition rates rise.
3. Vesting criteria too aggressive: Conversely, if the employer wants to make vesting more stringent or restrictive, it can add conditions such as EBITDA targets or IPO/change in control, which are considered performance conditions, or multiple of invested capital, which is a market condition. Stock-based compensation awards serve as incentives. Vesting conditions should be challenging enough to drive employees toward meaningful, but not unrealistic, achievement. If vesting goals are set too high, the awards may lose their motivational effect, working against their primary purpose of aligning employee efforts with company success.
4. Inconsistent record keeping: The executive team sometimes underestimates the amount of effort required to maintain legal documents, the cap table, vesting and exercising schedules. Good recordkeeping is crucial when the company goes through financial statement audits or financial due diligence. Without proper recordkeeping, financial statement audits and due diligence processes can be significantly prolonged. This can trigger higher audit and diligence fees, delays in closing the transaction, and even risking deal termination or substantial penalties (see the cautionary tale below).
5. Tax implications: The founders might overlook potential implications of income taxes and payroll taxes varying depending on the types of awards. Understanding the main differences between incentive stock options and non-qualified stock options is essential when creating equity incentive plans.
Accounting challenges regarding common forms of equity compensation
Startups frequently use equity compensation (e.g., stock options, restricted stock units, etc.), but many fail to grasp its accounting complexities. ASC 718 requires companies to recognize the FMV of these awards as an expense. Complexities arise with performance-based or market-based conditions, which require careful classification and tracking. Accountants must ensure that awards (liability or equity) are properly classified and they must monitor modifications that could lead to additional expenses.
Misclassifying these instruments above can result in misstated financial statements, which is especially problematic during audits or liquidity events (e.g., M&A, IPO). Failing to account properly for embedded derivatives or misclassifying equity and liabilities can lead to noncompliance with GAAP, potential penalties and loss of investor confidence.
Cautionary tale
One of our startup clients initiated their first financial statement audit to prepare for a Series A capital raise. They expected to complete the audit within eight to ten weeks, which is typical for companies with adequate staffing and strong internal controls. However, the audit dragged on for over a year due to significant recordkeeping issues. The company lacked a cap table, despite issuing multiple classes of preferred equity, stock options, restricted stock units, restricted stock awards, convertible debt, SAFEs and warrants. Some equity awards had even been granted without board approval. Reconstructing the cap table required extensive time from the management team, causing substantial delays.
After completing the cap table, the company engaged a third-party consultant to determine the appropriate accounting treatment for these equity instruments under ASC 718, ASC 480 and ASC 815 — a process that took additional weeks. In the tighter capital environment of 2022 to 2024 marked by higher interest rates, the company ultimately failed to secure the necessary working capital to sustain operations. Furthermore, due to poor recordkeeping, the company was required to amend prior-year tax returns, resulting in hefty penalties.
This case underscores the importance of maintaining accurate records and clear internal controls to avoid costly delays and risks during audits and capital-raising efforts.
Equity compensation is one of the most important tools startups have for preserving cash flow and retaining top talent. As a CPA, you play a critical advisory role in ensuring the company accounts for these instruments correctly, reducing the risk of costly restatements and ensuring compliance during future liquidity events. The startup culture runs fast and furious with constant pivots and reiterations. Don't let proper treatment of equity compensation get lost in all the excitement. That's where you come in.
