How Do Contractors Own Equity?
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Equity, also known as stock, represents a claim of ownership of the assets and earnings of a company. Companies typically grant stock options that, if conditions are met, can be converted into company shares. When this happens, the contractor becomes a stockholder.
The benefits of giving equity to contractors
The benefits of equity—in addition to ordinary income—for both contractor and hiring companies are significant:
- Equity incentivizes contractors to renew their independent contractor agreements instead of looking for new clients
- Equity allows contractors to reap some of the value they’ve helped create
- Equity is less expensive for early-stage startups to give as compensation since its true value accumulates over time
- Companies can gain access to the talent they would otherwise be unable to afford by partly paying them with equity
The disadvantages of giving equity to contractors
The disadvantages of equity compensation for contractors and hiring companies are as follows:
- Since contractors often have multiple clients, giving them stock options may create a conflict of interest. You’ll need to clear this up in advance of issuing them options
- Venture capitalists (VCs) prefer it when your cap table has many long-term employees. Distributing stock options among contractors carries the risk of dead equity – a situation when stock is owed to someone who isn’t involved in the business anymore. This can create headaches for VCs who would like to buy more of your company down the line
- More protections and clauses are necessary for equity agreements with contractors for the business relationship to make sense and ensure compliance. Since contractors often work on a short-term or project-by-project basis, putting in place mechanisms like vesting schedules, for example, is often unnecessary, and might give rise to a perception that the contractor is a misclassified employee.
Disclaimer: This content does not constitute legal advice. Please consult a legal professional.
Step one: Decide on the best types of stock options for your contractors
Depending on your contractors’ tax residency, some equity types are more favorable than others. For example, non-qualified stock options (NSOs) are regulated depending on the country, so if you offer equity to an international contractor in a country with a subsidiary, choosing an NSO will require localized contracts for compliance.
Restricted stock units (RSUs) are not regulated dependent on the country and therefore require less compliance footing, which is suitable for international contractors. However, restricted stock is typically only issued once the company has gone public or is about to go public, which means they aren’t always ideal for early-stage startups.
The different types of equity are as follows:
- NSOs: Non-Qualified Stock Options - companies tend to offer NSOs to international contractors during any stage of the company’s growth
- RTUs: Restricted Token Units (Crypto) - companies may choose to provide contractors with cryptocurrency during any stage of company growth
- RSUs: Restricted Stock Units - companies usually issue these to contractors at any stage of company growth
- SARs: Share Appreciation Rights - Companies offer these to contractors to enable them to receive the increase in value of a company’s stock over a set period
- ISOs: Incentive stock options - Companies should avoid issuing these to contractors since they entail tax obligations specific to employees and could result in a misclassification risk
- Gifting: While gifting shares is a rare occurrence made by super early-stage companies, it is possible to give shares to contractors
Step two: decide how much equity to give to contractors
Once you’ve settled on the type of equity you want to provide, you need to decide how much equity to give to contractors.
How much will depend on numerous factors such as:
- The stage of your company
- The fair market value of the company and value of the stock (which changes over time)
- The contractor's experience or performance
- The length of the relationship
- The level of risk involved
For each contractor, try to set your baseline as the minimum amount you need to offer that contractor to incentivize them. With that in mind, you’ll also need to consider that equity has more of a risk factor than cash incentives. The percentage you ultimately land upon depends on how valuable the contractor’s work is to your company and the market demand for their skillset.
Step three: Choose how to structure equity incentives
Here are a few common equity structures for contractors:
- Time-based: The contractor earns equity over a fixed period of time (typically in years) with a specific percentage vested at each date. This is the most common approach.
- Milestone-based: Equity is earned based on the contractor achieving certain milestones. For a salesperson, the milestone could be a certain sales target. For a software engineer, it could be a specific release date of the company’s product.
The best structure will depend on the lifecycle of the contractor and the level of complexity you’re willing to take on. For example, a milestone structure is harder to implement since contractors typically work in shorter cycles. You’d need to define product delivery which can be more ambiguous from a legal standpoint.
Avoid worker misclassification risks
Not sure if you should classify a worker as an employee or independent contractor? Follow these three US tests for guidance.
Step four: Draft an equity agreement also known as a stock option grant
Once you’ve worked out all the details, it’s time to devise an equity agreement that discloses the contractor’s rights to purchase equity at your company.
An equity agreement should include the following components:
- The type of equity they’re getting
- The number of shares granted
- Their strike price (or exercise price)
- The vesting schedule (or vesting period)
- Whether early exercise is allowed
- How their shares are affected by acquisition or termination
- Any restrictions on the selling of equity
- The tax implications of exercising (and selling shares)
- The terms and conditions of the service arrangement that will result in a grant of equity to the contractor
- Their post-termination exercise window
- How to protect confidential information
- Which terms survive the agreement
- An arbitration clause if a dispute arises under the agreement
- The governing jurisdiction. Often the jurisdiction in which the company operates, but this will vary for global companies
Step five: Educate your contractors
It is up to the contractor to determine whether they will give up some of their money in return for company equity. And for many, equity will likely be a new topic, full of new and complicated terms and concepts.
Before a contractor accepts and signs their equity grant, they’ll need to know what it is, how it could benefit them, and how purchasing equity could impact their tax treatment and financial standing.
Equity without the right context can be counterproductive because the economic benefit of ownership (especially with private companies) isn’t intuitively obvious.
For a baseline level of knowledge, contractors need to understand the following:
- All equity involves risk. If a company fails or gets acquired at an unfavorable valuation, then its shares may not end up with much or any value
- A diversified portfolio is the safest. Investing too much money in the company can lead to non-optimized decision-making
- Tax responsibilities increase. Depending on the type of shares, and tax rate, different tax treatments will apply to income tax and long-term capital gains
- The potential upside. Based on the strike price and the company’s current valuation, what kind of value a contractor expect to see during a liquidity event
Companies should compile educational resources to help their contractors understand the terminology, processes, clauses, and obligations. If you partner with an equity service provider, like Deel, they will have educational resources on-hand that you can share with your contractors to get them up to speed.
Step six: Fulfill your tax reporting obligations
In the US, for example, if the fair market value of the shares increases from the exercise price in the initial share award to the contractor, the contractor must pay taxes under the alternative minimum tax regime (AMT).
If the US contractor can exercise their shares early, the contractor must submit a copy of form 83(b) to the Internal Revenue Service (IRS) and the company; the company must retain a physical copy.
The company must also file other IRS forms in other scenarios, for example, when it has issued $10m in options in one calendar year.
If the fair market value remained the same as the exercise price when the company granted the shares, there is no taxable event.
If a company “gifts” a contractor shares, this is a taxable event. The company must distribute the correct tax forms so that the contractor can report these earnings as miscellaneous income. This process is the same for most countries.
Grant contractors equity with Deel
With Deel, get unmatched legal and tax support to grant your global contractors equity. We’ll help you decide the best equity type for your team, take care of payroll, and report any taxable events based on the type of equity you grant and where you grant it.
Whether you have general questions about equity compliance or need help navigating new global equity options, our experts are here to help. Get in touch with our team today.