Stock compensation in early stage start-ups: Shares or Stock options?

I have a question regarding compensation for key employees in early stage start-ups. From an employee and company standpoint which one is better? Shares or stock options? For example: Consider an early stage venture that has total share capital of say Rs.5Cr (50L shares at Rs.10 par value) post first round funding. They would like to hire a senior professional as the CEO. The CEO will take a huge pay cut in lieu of 10% equity (with a 4 yr vesting period) in the company. I can think of two ways to implement this:

1. Allotting shares to the CEO: 10% equity would amount to about 5.5L newly issued shares and new share capital of Rs.55L. However this would be a huge expense on the company’s books (even though there is no cash exchange. The company gives 55L to the executive and he/she gives it back by purchasing 5.5L shares). Is there any way the company can allot shares without incurring the expense on the books? Can shares be transferred from existing shareholders to the executive?
2. Stock options: The company can issue 5.5L stock options with a strike price of Rs.10. In this case what are the rights of option holders (ie the executive)? Is he/she eligible for dividends, bonus share grants, voting rights etc?

I am sure people in venturewoods must have faced this issue. Which is a better option?

6 Responses to “Stock compensation in early stage start-ups: Shares or Stock options?”

  1. Vamsi, Yes, the CEO needs to pay you Rs. 50L. Now you can provide the money to him as a soft loan and sell him shares and he pays you with the same money you lent him. This “getting back” could entail a capital gain but if you sell the shares at par (assuming you bought them at par) there is no capital gain involved.

    Shares should not be transferred free of cost, as the capital structure may a) bring in the taxman who says it’s a deemed benefit that should be taxed as income in the buyer’s hands and b) it’ll appear in due diligence forever and you will be asked why every single time.

    http://www.nseindia.com/content/nsccl/nsccl_focorpactions.htm is the link for how NSE does adjustment for options when there are dividends and bonuses. This does not apply to private firms – I don’t know if there are any regulations saying you have to do it like the NSE. But if you do use it, explaining will be easier to the tax department why it was done this way.

    I’d slightly disagree with Krish. (but yes, dividends and bonuses are probably not that big a deal to think about right now) I’ve been through a legal due diligence in the recent past, during the sale of my last employer. The accountants and lawyers will find every nit picking way to stall and question and negotiate, and if you screw up something like stock based compensation you will end up in accountant/legal hell, or at least make you believe hell exists. Keep it simple, but don’t shove it aside and “work it out later”.

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