A 2019 survey revealed that most employees preferred working for an established public company with an equity compensation program. The number is expected to be higher now, especially among younger employees.
Equity compensation has become increasingly popular as startups and small businesses seek to attract and retain top talent. Incentive units and stock options—two popular types—differ in structure, tax treatment, and suitability depending on the organisational form.
Which option is best for your company’s specific structures or employee goals?
This article explains the essential aspects of incentive units and stock options, detailing key factors such as vesting schedules, tax implications, and use cases.
Understanding these differences can help you make informed compensation decisions, whether you're a startup founder, HR manager, or prospective employee.
TL/DR: Key takeaways from this article
- Incentive units and stock options are forms of equity compensation with distinct benefits.
- Incentive units typically apply to LLCs and require conditions like performance milestones for employees to earn equity.
- Stock options give employees the right to purchase stock at a fixed price, which is suitable for corporations and growth-stage startups.
- Ownership structures differ, with incentive units linked to membership interests and stock options to company shares.
- Tax treatment varies; incentive units often incur income tax at vesting, while stock options differ based on type (ISOs vs NSOs).
- Choosing the right form depends on company structure, tax considerations, and strategic goals.
Overview of incentive units and stock options
Incentive units and stock options are used as equity-based compensation. Here’s what they mean.
What are incentive units?
Incentive units are equity-based compensation used mainly by Limited Liability Companies (LLCs). Unlike traditional stock options, common in corporations, incentive units represent membership interests within an LLC.
Equity can be awarded to employees, founders, or stakeholders who meet specific performance or tenure milestones. Incentive units provide ownership based on a person’s contribution and achievements, allowing companies to design customised reward structures.
For example, an LLC may grant incentive units that only vest if the company achieves certain financial targets (performance-based) or if an employee reaches a set tenure (time-based). These units align individual performance with company goals, making them attractive to private companies that want to reward long-term impact.
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What are stock options?
Stock options let employees in corporations purchase shares at a pre-established price, known as the exercise or strike price. Stock options help corporations retain talent by giving employees a stake in the company’s future growth, often with vesting schedules that reward long-term commitment.
They are particularly popular with incorporated startups aiming to attract high-potential talent.
Two main types exist:
- Incentive stock options (ISOs): Offer favourable tax treatment but are subject to strict eligibility and holding requirements.
- Non-qualified stock options (NSOs): These are more widely granted and have fewer restrictions, but they are taxed at regular income rates upon exercise.
Primary differences between ISOs and NSOs
| ISO | NSO | |
| Eligibility | Only common-law employees. Recipients must be a person; ISOs can't be issued to entities. | Employees and independent contractors (including non-employee directors). |
| Limits on post-employment exercise period | Yes. The option must be exercised within three months after termination of employment (it can be extended for death or disability). | No. NSO may be exercised at any time before the option expiration date. |
| Maximum permitted term | Ten years from the grant date for standard issuances but five years for options granted to greater than 10% of the company's voting stock. | None (though they are commonly set at ten years from the grant date). |
Key differences between incentive units and stock options
Now, back to incentive units and stock options, the following are the differences:
Ownership and structure differences
Ownership structures differ between incentive units and stock options:
- Incentive units are designed for LLCs; they represent membership interests rather than traditional stock. Upon vesting, recipients become members of the LLC with voting rights and profit-sharing benefits.
- Stock options are primarily for corporations and allow employees to purchase company shares. Until exercised, these options do not grant ownership but provide a future right to buy shares.
Vesting schedules and conditions
Incentive units and stock options follow vesting schedules based on time or performance milestones. However:
- Incentive units offer more flexibility, allowing companies to set conditions tied to specific achievements or financial goals.
- Stock options commonly have fixed time-based vesting, such as four years with a one-year cliff. This setup ensures that employees stay with the company for a minimum period before options become exercisable.
Valuation and liquidity
Valuation and liquidity aren’t the same for incentive units and stock options.
- Incentive units may not have a set value upon issuance. Instead, they can fluctuate based on the company’s performance or valuation at a future liquidity event.
- Stock options, on the other hand, are issued with a fixed exercise price; their value is determined by the stock’s market price. Employees can convert these to shares, providing liquidity through public markets or during a company’s exit event, such as an IPO or acquisition.
Tax considerations of incentive units vs stock options
Here are the tax considerations for both equity compensation types:
Tax treatment of incentive units
Incentive units are generally taxed as ordinary income when vested. However, tax timing can vary based on vesting conditions and company performance.
Employees might be able to file an 83(b) election, allowing them to pay taxes on the fair market value at the time of grant rather than vesting. This approach can lead to significant tax savings if the company’s value rises over time.
Tax treatment of stock options (ISOs and NSOs)
Taxation of stock options varies based on the stock option type.
- ISOs receive favourable tax treatment, with gains potentially taxed as capital gains if held for the required period. However, the Alternative Minimum Tax (AMT) may apply.
- NSOs are taxed at ordinary income rates upon exercise, as they are not subject to the same regulatory requirements as ISOs.
When are incentive units and stock options taxed?
Understanding the timing of taxation is essential for both types:
- Incentive units are taxed either at grant (with an 83(b) election) or upon vesting, based on the fair market value.
- For stock options, ISOs are taxed upon sale, while NSOs are taxed upon exercise.
Use cases: When to use incentive units vs stock options
Incentive units (for LLCs and private companies)
LLCs and private companies prefer incentive units due to their flexibility. They allow companies to tailor equity-based compensation to align with specific performance goals or company milestones, fostering a strong alignment with growth objectives.
Stock options (for corporations and growth-stage startups)
Stock options are more suitable for corporations or rapidly growing startups looking to attract talent with the potential for equity ownership. Offering stock options helps these companies attract top talent and retain employees motivated by the possibility of future equity value.
Comparing incentive units and performance units
Here’s a clear comparison of incentive units and performance units:
- Performance units, primarily used by corporations, don’t provide ownership. Instead, they are conditional rewards linked to achieving predefined company goals, often paid out in cash or stock equivalents once the targets are met.
- Incentive units, common in LLCs, offer an ownership stake to employees or partners, with rewards often tied to company performance or individual milestones. This structure allows flexibility in customising compensation based on specific achievements.
Essentially, incentive units confer potential ownership, while performance units are non-ownership rewards, but both are contingent on performance.
The table outlines the key differences between incentive units and stock options.
| Incentive units | Stock options | |
| Used by | LLCs and private companies. | Corporations, especially public or growth-stage companies. |
| Ownership | Grants equity interest (ownership) in the company. | Has the option to purchase shares in the future. |
| Vesting | Performance or time-based milestones. | Time-based, often with a standard four-year vesting schedule. |
| Taxation | Generally taxed as ordinary income upon vesting | ISOs are taxed favourably because they qualify for long-term capital gains; NSOs are taxed at ordinary income rates. |
| Liquidity | Less liquid, dependent on company exit or liquidity event. | More liquid, dependent on option exercise or company liquidity event. |
| Flexibility | Customisable to company goals and structure. | Standardised terms for exercise and valuation. |
| Eligibility | Offered to partners and employees in an LLC. | ISOs are limited to only employees; NSOs can be granted to employees and non-employees. |
Frequently asked questions (FAQs) about incentive units and stock options
What is the difference between options and units?
Options provide a future right to buy shares, while units represent membership interest, particularly in LLCs, often awarded based on specific conditions (e.g. performance).
How do incentive stock options (ISOs) work?
Incentive stock options (ISOs) are equity compensation primarily offered by corporations to employees. Here’s how they work:
- The company grants ISOs, which give employees the right to purchase stock at a strike price—typically lower than the current market price.
- Generally, ISOs have a vesting schedule, which means that employees must wait a specified period before they can exercise the options.
- Once vested, employees can choose to exercise their options, buying shares at the strike price.
- Employees holding ISOs for at least one year after exercising and two years from the grant date may qualify for long-term capital gains tax on any profits when they sell the stock. However, if they sell earlier, they may incur alternative minimum tax (AMT) or ordinary income tax rates, depending on timing and other factors.
When are incentive stock options taxed?
ISOs are generally taxed upon the sale of the stock, assuming the employee meets specific holding requirements: at least two years from the grant date and one year from the exercise date. Meeting these requirements allows the gain to be taxed at the lower capital gains rate instead of ordinary income rates.
What is the difference between NQ and ISO?
NQ (non-qualified) stock options are taxed as ordinary income at exercise, based on the difference between the exercise price and market value. ISOs, however, qualify for favourable capital gains tax treatment upon sale if holding requirements are met, potentially reducing the tax burden for employees.
Are incentive units better for small companies?
Yes, incentive units can be especially advantageous for small companies, particularly those structured as LLCs. They offer flexibility in designing compensation to align with company goals and individual or team performance without directly issuing stock or requiring complex equity management.
Are restricted stock units (RSU) better than stock options?
It depends on the employee's goals, risk tolerance, and the company's growth stage.
RSUs provide shares outright, so their value is more predictable. Employees receive stock upon meeting vesting requirements. They are taxed as income upon vesting, making them generally lower-risk but with limited upside if the company's value grows significantly.
Stock options, however, allow employees to buy shares at a set price, potentially yielding greater gains if the company's value rises. They involve higher risk, as they can lose value if the company’s stock price declines. Stock options may appeal to those willing to take this risk for potentially higher rewards.
RSUs generally suit employees seeking more stable compensation, while options may suit those prioritising long-term equity growth.
Conclusion
Incentive units and stock options offer unique benefits and limitations depending on the company structure, employee goals, and tax implications. For LLCs, incentive units are a flexible way to reward achievement and retain key talent, while corporations and growth-stage startups may find stock options more suitable for aligning employees with future company success.
In choosing between the two, companies should consider ownership structure, taxation, and strategic goals, ensuring that the option aligns with long-term objectives and rewards the efforts of key employees effectively.
Glossary of common equity compensation terms
- Equity compensation: A non-cash payment offered to employees or stakeholders, often in the form of company shares, membership interests, or options.
- Vesting: The process by which an employee earns the right to equity (such as incentive units or stock options) over time or after meeting specific conditions.
- Vesting schedule: A timeline that dictates when an employee earns full ownership of granted equity compensation, such as stock options or incentive units.
- Cliff vesting: A vesting schedule where equity is earned in bulk after an initial period (e.g., one year), followed by incremental vesting.
- 83(b) Election: A tax provision allowing employees to pay taxes on the grant date value of equity rather than waiting until it vests, potentially reducing their tax burden.
- Strike price or exercise price: The pre-determined price at which employees can purchase shares through stock options.
- Membership interests: ownership stakes in an LLC, often representing profit-sharing rights and voting power.
- Performance units: compensation tied to achieving specific company goals, often paid as cash or shares, without granting ownership.
- Liquidity event: A significant financial event (e.g., acquisition or IPO) that allows equity holders to convert their holdings into cash or marketable shares.
- Capital gains tax: A tax on the profit from selling an asset like stocks, typically lower than ordinary income tax rates if certain conditions are met.
- Alternative Minimum Tax (AMT): A parallel tax system ensuring high earners pay a minimum level of taxes, often triggered by ISOs.
- Fair market value (FMV): The price of a company's stock as determined in the open market or by an independent valuation.
