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Restricted Equity v. Options & 83(b) Elections

November 7, 2018   |   By Nic O'Brien

Recently formed companies often issue restricted equity to stakeholders, but once the companies close a funding round or achieve significant revenue, restricted equity is inappropriate. Instead, the company needs an option plan and to issue options. This blog will answer, what is the difference between restricted equity and options that necessitates issuing options? Plus, when is the 83(b) election applicable to option and restricted equity recipients?

Restricted Equity is Purchased Today for A Nominal Value

Restricted equity is typically granted and purchased at par value (a nominal value, often $0.0001). The recipient purchases and owns all of the equity up front, subject to restrictions on transfer, a repurchase option, or both. Restricted equity is appropriate when a company has a high market value (based on its potential), but the company’s book value to the IRS is next to nothing because the company has no real revenue or assets. Thus, the recipients probably have the available cash to purchase the equity for the nominal price up front.

But once companies undergo a financing round or have significant amounts of revenue, the companies can no longer justify issuances of nominally priced equity to the IRS. The equity has a significant value, and to the IRS, a company issuing restricted equity for a price discounted from market value creates income, which the equity holder must pay taxes on. Thus, after an increase in value of the company, the equity’s exercise price must also increase from the nominal value. Assuming a company has 10,000,000 shares or units, each share or unit may be worth at least $0.30 now.

Theoretically, restricted equity issuances are still available, but practically, their issuance would be problematic. Because value is transferred today, recipients pay for the value today, and the recipients can’t or won’t want to pay the $30,000 price tag that comes with 100,000 shares or units at $0.30 each. Options solve this valuation problem.

Options Vest and are Exercised Over Time, Preventing Up-Front Payment

Options are when a company grants a recipient the choice to purchase a certain amount of equity at a certain price. Typically, the recipient cannot exercise the option to purchase all of the equity at once. Instead, the recipient must wait a certain time period for the options to become exercisable or to “vest.” Unlike restricted equity, where all equity is granted initially, options vest over time (or upon milestones), usually in equal monthly increments. The recipients receive no income when they purchase the options, so they owe nothing to the company or the IRS. The recipient only owes the company (and maybe the IRS) upon the eventual exercise of the options. Assuming the equity’s fair market value has increased more than the exercise price, the recipient will be able to afford and pay the company the higher price of each option, and the necessary taxes.

In summary, restricted equity is only practically applicable when a company has nominal value. Once a company has significant revenue or raises a financing round, options are the practical vehicle to issue equity. It is important for companies to know which form of equity to issue. Similarly, equity recipients must understand whether or not they should utilize the 83(b) election.

Restricted Equity Recipients Should File an 83(B) Election

Under Section 83 of the Internal Revenue Code, equity purchased that is subject to vesting or otherwise carries with it a “substantial risk of forfeiture” is not recognized as income until that equity has fully vested or until the “substantial risk of forfeiture” has passed. Moreover, the purchaser does not have to pay taxes on that equity until it is recognized as income.

An 83(b) election accelerates the recognition of a purchaser’s equity as income to the year in which the equity was purchased, in an effort to recognize income when the equity is at its lowest value. This ensures that the amount of income recognized, and the taxes paid, is as low as possible and establishes that amount of income recognized as the purchaser’s tax basis in the equity.

Again, the election is only available for equity that is subject to vesting or equity that faces a “substantial risk of forfeiture.” A substantial risk of forfeiture exists when:

  1. granting equity is conditioned upon the performance of substantial services or on a condition happening, and
  2. on the day of the grant, a real chance exists that the services won’t be performed or the condition won’t be achieved.

When a recipient receives restricted equity, the recipient should most likely file an 83(b) election. Restricted unit purchase agreements or restricted stock purchase agreements are restricted equity vehicles to immediately give a key recipient equity. The recipient is incentivized to stay with the company because the equity is subject to a repurchase option. If the recipient leaves, the company will apply the repurchase option to repurchase the equity that has not yet been released from the repurchase option. Because this restricted equity may be repurchased and lost, there is a substantial risk of forfeiting the equity, allowing for the 83(b) election.

83(b) Elections are Unnecessary for Option Recipients

Unlike restricted equity, which is purchased in full at the time of the grant, an option to purchase equity is not considered income until it’s exercised, and the option recipient does not pay taxes on the equity until it is exercised or sold. Because of this delay in ownership, there is no substantial risk of forfeiture with options, and an 83(b) election is not necessary.

Alternatively, because restricted equity is subject to a substantial risk of forfeiture and the gain is recognized right away, an 83(b) election is a useful tool to lower eventual income received and the taxes paid by the recipients.

In conclusion, restricted equity is usually issued when the company has nominal value, and the recipients of the restricted equity should most likely exercise the 83(b) election. Conversely, options should be issued once a company raises capital or achieves significant revenues, and because options lack a substantial risk of forfeiture, option recipients should rarely exercise the 83(b) election.

Please note that this is complex stuff and you should not rely on this blog to make decisions for you. Please consult with your legal counsel and tax advisors for all matters pertaining to 83(b) elections.

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Posted in Funding & Capital Raising
Nic O'Brien
Nic O'Brien is an associate at Vela Wood. He focuses his practice in the areas of venture financings, mergers and acquisitions, commercial and technology transactions, and general corporate governance. You can see Nic's attorney profile here.