In today’s business environment, talent acquisition and retention are top priorities for employers of all sizes, especially contractors. Skilled and experienced employees are in high demand. Increasing base pay may not be enough to retain valuable employees who want to have some “skin in the game” with their company. Bonus and commission structures can be a solution in some instances, but they don’t always create the right incentives or an “ownership mentality.” In addition, increasing base compensation and offering bonuses can be costly to owners and put a strain on the company’s budget. This is where a well-crafted equity incentive plan can create a win-win situation for employers and employees.

An equity incentive is a form of ownership in a company granted to an employee that is subject to certain conditions – in particular, that the recipient remains employed by the company. An equity incentive usually has a vesting structure that grants the recipient additional equity in the company the longer the employee remains employed by the company.

There are various types of equity incentive awards, but the most common for small to midsize businesses are restricted stock units (RSUs) and stock options. These structures tend to work well for contractors, but any equity incentive plan for a contractor needs to be carefully crafted to consider licensing, financing and surety issues.

Following is a discussion of some of the structures and characteristics of RSUs and stock options, along with the legal documentation requirements for both. This discussion assumes a corporate structure, but LLCs and other entities can also adopt equity incentive plans.

Restricted stock units

RSUs are a promise by the employer to issue the employee a set number shares of the company subject to a vesting schedule. The employee does not actually receive shares until they are vested, which means the employee will not have any voting or dividend rights until the shares are vested and issued. Vesting schedules vary, but they are usually tied to continued employment, with a percentage of the shares vesting each year. RSUs can provide tax benefits to employers by allowing the company to take a tax deduction equal to the value of the vested RSUs.

Stock options

Stock options give employees the right to buy a company’s stock at a preset exercise price. The value of a stock option is the current price of the stock minus the option exercise price. Stock options can have vesting schedules as well, with a portion of the shares becoming available for exercise at specified dates and subject to specified conditions (e.g., continued employment).

The taxation of stock options depends on whether they are nonqualified stock options (NQOs) or incentive stock options (ISOs). NQOs are more flexible than ISOs and can provide employers with a tax benefit. When an employee exercises an NQO, the employee generally pays ordinary income tax on the difference between the exercise price and the fair market value of the shares at the time of exercise, and the employer can take a tax deduction equal to that ordinary income amount. ISOs are more favorable to employees because the employee can defer income tax until the shares purchased on exercise of an ISO are sold to a third party; there is no tax on the exercise itself.

However, ISOs are not as flexible as NQOs and are subject to various requirements, including holding periods, termination dates, exercise price restrictions, stock ownership limits, and annual exercise limits.

RSUs, ISOs, NQOs, and other types of equity incentive structures each have unique and sometimes complex tax, securities, accounting and corporate governance aspects, all of which need to be evaluated before implementation.

Legal documentation

Whether issuing RSUs or stock options, the legal documents are fairly similar. The company must adopt an equity incentive plan that details the types of awards the company can grant, the management of the plan (usually through the company’s board of directors or compensation committee), and the mechanics and authority to grant awards. The plans are usually general and allow the company to issue different types of awards subject to vesting and other conditions as the plan manager may determine. The plan can also contain restrictions on transfers and certain buyout mechanisms.

An award agreement is also necessary and is entered into between the company and each employee receiving an award. The award agreement will detail the type of equity incentive being awarded, the vesting schedule, exercise price and mechanics (if stock options are being granted), and other conditions related to the specific award. It is also best practice to have authorizing resolutions from the board of directors of the company that approve the plan documents and each award granted pursuant to the plan.

Contractors, like all talent employers, need to have tools to attract and retain talent. Equity incentive plans can be the answer, but need to be carefully planned, documented and communicated.

Blake Bowman is an attorney with Schwabe, Williamson & Wyatt. Contact him at 503-796-2761 or bbowman@schwabe.com.

Column first appeared in the Oregon Daily Journal of Commerce on September 24, 2019.