Equity Compensation Beyond Startups: Options, RSUs, and Phantom Stock

For private companies, equity compensation is more complex than at public companies—there's no liquid market for shares, 409A valuations are required, and employees face unique challenges around exercising options and paying taxes.

This guide covers the main equity compensation vehicles available to private companies, their tax implications, and practical considerations for implementation.

Why Use Equity Compensation?

Benefits for Companies

• Alignment: Employees think like owners when they own (or will own) part of the company
• Retention: Vesting schedules create golden handcuffs
• Cash conservation: Equity provides value without immediate cash outlay
• Competitive recruiting: Equity upside attracts talent willing to take risk

Challenges

• Dilution: Granting equity reduces ownership for existing shareholders
• Complexity: Equity plans require legal, tax, and administrative infrastructure
• Valuation: Private company shares need regular 409A valuations
• Employee education: Many employees don't understand equity value or mechanics
• Liquidity: No market for private shares until a liquidity event

Stock Options (ISOs and NSOs)

Stock options give employees the right to purchase company stock at a fixed price (the exercise price) in the future.

Key Terms

• Grant: When options are awarded to the employee
• Exercise price (strike price): Price employee pays to buy shares (set at FMV on grant date)
• Vesting: Schedule over which options become exercisable
• Exercise: When employee pays the strike price to receive shares
• Expiration: Options typically expire 10 years after grant

ISO vs. NSO

Private Company Challenges

• Cash for exercise: Employees need cash to exercise, but shares aren't liquid
• Tax on exercise: Tax may be owed before shares can be sold
• Expiration post-termination: Standard 90-day exercise window post-departure is problematic

Restricted Stock Units (RSUs)

RSUs are promises to deliver actual shares of stock when vesting conditions are met. Unlike options, there's no exercise price—the employee receives shares (or equivalent value) for free.

How RSUs Work

• Grant: Company promises future shares
• Vesting: Shares delivered when vesting conditions met
• Settlement: Shares (or cash) delivered; taxed as ordinary income

RSU Advantages

• Value even if stock falls: Always worth something (unlike underwater options)
• No exercise decision: Simpler for employees to understand
• No cash outlay: Employee doesn't need to pay anything

Private Company RSU Challenges

• Tax at vesting: Ordinary income recognized when shares vest, but no liquid market
• Tax withholding: Company must withhold taxes, often by selling shares (hard without market)
• Double-trigger: Many private companies use double-trigger RSUs that don't fully vest until liquidity event

Phantom Stock and Stock Appreciation Rights

Phantom stock and SARs provide economic exposure to stock value without actual share ownership. These are particularly useful for private companies that don't want to issue actual shares.

Phantom Stock

Cash bonus tied to the value of a hypothetical number of shares:

• Employee receives a grant of "units" tied to stock value
• Units vest over time like real equity
• Upon liquidity event or defined period, employee receives cash equal to share value
• Some plans include dividend equivalents

Stock Appreciation Rights (SARs)

Similar to options, but employee receives cash equal to appreciation:

• Grant specifies a base value (like strike price)
• At exercise, employee receives cash for appreciation above base
• No actual stock changes hands

Advantages of Phantom Equity

• No dilution: No actual shares issued
• No shareholder rights: Recipients don't vote or have access to company information
• Simpler administration: No cap table changes, no securities filings
• Cash settlement: Liquidity guaranteed at payout

Disadvantages

• Cash outlay: Company must fund payouts (unlike equity)
• Accounting: Liability accounting with ongoing mark-to-market
• Perception: May feel less valuable than "real" equity to employees

Profits Interests (LLCs/Partnerships)

For companies structured as LLCs or partnerships, profits interests are the typical equity compensation vehicle.

How Profits Interests Work

• Recipient receives a share of future profits and appreciation
• No claim on existing company value (set at a "threshold" equal to current value)
• Can be structured to participate only in exit proceeds or also in distributions
• If properly structured, no tax at grant

Tax Treatment

• At grant: No income if threshold equals current FMV
• At vesting: No income event (unlike RSUs)
• At sale: Capital gains treatment on appreciation
• Ongoing: May receive K-1 for share of profits (creates tax complexity)

Implementing an Equity Plan

Key Steps

• Choose vehicle: Options, RSUs, phantom stock, or profits interests based on company structure and goals
• Determine pool size: Typically 10-20% of fully diluted shares for employee pool
• Define eligibility: Which employees will receive equity?
• Set grant guidelines: How much equity for each level/role?
• Establish vesting: Standard is 4-year vesting with 1-year cliff
• Obtain 409A valuation: Required for options; recommended regardless
• Draft legal documents: Plan document and individual award agreements
• Board approval: Equity plans require board (and often shareholder) approval

Employee Communication

• Explain how the equity works in simple terms
• Model potential values at different exit scenarios
• Clarify vesting, exercise requirements, and expiration
• Provide resources on tax implications
• Regular updates on company value (409A or other valuation)