United States: Equity Compensation For Private Companies: The Six Pitfalls To Avoid

Last Updated: September 22 2015
Article by Armanino LLP


In privately held companies, equity compensation – the granting of stock options, restricted stock, and other instruments tied to future compensation – offers a tremendous advantage in attracting and retaining talented employees. However, thanks to myriad laws and regulations around the world, equity compensation is also one of the most difficult challenges that spans finance, legal, tax, and HR disciplines.

For private companies, those challenges can be more acute because they create a disproportionate burden on typically leaner organizations that still must avoid or minimize the equity compensation traps and pitfalls, and stay in compliance. The following white paper describes several prominent and common pitfalls that private companies will want to avoid in the design and administration of their equity incentive plans.


If you haven't been immersed in the complexities of a stock option plan, you might not realize how many different areas of the company are directly involved in administering the equity compensation lifecycle. With so many stakeholders involved, the opportunity for process breakdown increases exponentially. Be sure the processes underpinning your equity plan involve all of those stakeholders so that you can understand their needs/restrictions, tap their expertise and sidestep the easy mistakes.


One of the most common – and preventable – pitfalls happens when there's a communication breakdown among key stakeholders. For instance, does your Board of Directors get properly notified about the grants to be issued to new hires? How do your participants get notified of a grant? How does a participant initiate an exercise? A lapse in any of these processes can lead to major problems down the road if the company has overcommitted grants or an employee never signed his/her paperwork for example.


It's essential to design and execute the basic workflows that underpin equity administration to ensure all steps are followed consistently and that your company remains in compliance. For example, have you defined the steps that should be taken to collect tax or exercise price payments in a timely, accurate fashion? Who handles that process? Have you ensured smooth hand-offs between plan administrators, accounting, and HR? Who, for instance, enters the data and initiates a process? Who issues approvals to ensure there's proper authorization and visibility?

From a broader perspective, what's missing in many private companies is a "Process Manual" for equity compensation. You need a single go-to resource where all of your process stakeholders can see clear instructions, definitions, and steps. This helps ensure continuity and transition in the face of inevitable staffing changes throughout your company, or when there is a long gap between executing certain tasks. In addition, individual contributors tend to wear multiple hats in private companies. The payroll administrator might also be the plan administrator, or the accounting manager issues new grants for example. Having a manual that defines the roles and responsibilities, regardless of title, but by process, is key in case someone is filling in or taking over or only contributes a small percentage of their job to equity administration.

Using a third-party advisor or vendor can help you simplify the task by leveraging their expertise. In addition, they may provide an objective viewpoint or industry best-practices. Engaging stakeholders, bringing in the right expertise, and creating documentation are key steps to streamlined, accurate, and repeatable processes.

Knowledge Gaps

By improving communication and coordination, your company will inevitably expose different knowledge gaps. Maybe the news regarding new hires isn't getting entered into your board minutes. Or decisions from board meetings aren't getting reflected in your plan administration processes and spreadsheets. For instance, the board might approve a change in vesting schedules – but that needs to get reflected in the actual grant agreements that HR communicates to employees. Or the board might become aware of a lack of shares to grant new employees, necessitating revisions to the current structure. You might even detect an improper practice of granting Incentive Stock Options to nonemployees. Closing these knowledge gaps quickly and thoroughly improves your compliance posture and helps you avoid numerous headaches down the road.


The simple spreadsheet might be the one tool that a finance department in a private company simply can't do without. Spreadsheets are attractive because they're flexible, inexpensive, and widely used. But when it comes to managing equity compensation, the compliance and tracking burdens quickly outweigh the capabilities of even the most robust spreadsheet models, which are inherently fragile and highly resistant to clean audits. Spreadsheets don't have the benefits of a robust safety net with backups, security, authorizations, and approvals, to name a few.

Another gotcha is that spreadsheets often morph over time, accumulating a series of plugs and workaround mysteries known only to the owner/creator. And if that owner terminates, that extensive spreadsheet knowledge leaves your organization. Errors in formulas can be easy to create and maddening to detect. Then, there are the workbooks with multiple spreadsheets for cap tables, options, expenses, and more – or even worse, it's all tracked in separate workbooks. Their unwieldiness acts as a silent limitation on the amount of data you can feasibly track. And there's typically little (or no) built-in intelligence/data validation. For instance, if you forget to vest an RSU, the stock will not show on the cap table. Or another common glitch relates to the ISO $100,000 rule, and splitting a grant between its qualified and non-qualified portions.

As a result, spreadsheet-managed equity programs typically receive greater scrutiny from auditors, but also just simply take longer to audit due to data formatting, inconsistency, following formulas from sheet to sheet, etc. There are also potential internal controls issues as far as who has access to the spreadsheet and how updates are managed.

Lastly, although spreadsheets are flexible, they may not be dynamic. For example, when regulations change (as they often do), it might not be easy to systematically change the spreadsheet structure to accommodate the changes, not to mention having the internal expertise to monitor and implement them. And related to flexibility, perhaps the biggest challenge with spreadsheets is covered in our next topic – modification mistakes.


Revisions to equity compensation plans are an ever-present reality, so you need the agility to adapt on the fly as your company's needs change, but to also fully understand the ramifications of such changes. A modification is defined by Accounting Standards Codification (ASC) 718 (formerly FAS123R) as a change in any of the terms and conditions of a stock-based compensation award. Note that "terms" can mean more than simply a vesting schedule or strike price – it can encompass all aspects of the grant. A modification may impact stock-based compensation expense as well as corporate and individual taxes.

For accounting purposes, the result of a modification is equivalent to canceling the original award and granting a new option with new terms. Depending on the modification, award-type, etc., finance and/ or tax must make a determination about the expensing of the new award and assess the potential tax impact. This typically involves a change in the fair value of the award before and after the modification. On the tax side, the change in expense changes the timing of deduction - both for the corporation, as well as the tax eligibility for the individual.

In too many instances, the consequences of modifications slide off the radar (and elude any accountability) because they're either "one-off's" or they transpire at lower levels of the organization. For instance, a terminating employee might be given credit for a "milestone cliff" that wasn't reached or other vesting accelerations. Or he might simply receive an extra month's shares.

Or, although the original option agreement called for a three-month post-termination exercise window, the company might want to extend that to 12 months. Such changes can have tax and accounting consequences that must be addressed (and, in this example, could potentially disqualify an ISO award). Other changes involving either a shift in performance metrics to a purely time-based vesting scheme, or a change to performance targets should also be properly addressed.

A change in an employee's status (such as becoming an independent consultant to the company) needn't require you to issue new awards, but it might change the accounting for that grant, such as moving from fixed accounting (i.e. grant-date fair value) to variable accounting (i.e. mark-to-market).

In addition to understanding the consequences, the key criteria for managing modifications are your processes and traceability. Process was discussed above, but you must also have the ability to accurately track what happened, both from administrative and accounting perspectives. This can be a challenge depending on your system of record.


One of the biggest pitfalls for private companies lies in effectively and proactively managing the potential tax implications of various events and decisions. One of the thorniest areas is the ISO/NSO split. Many finance teams in private companies may not be aware of the importance of the nuances and distinctions (e.g. the $100,000 limit) or struggle to manage that in simple spreadsheets.

NSOs as well as restricted stock, for instance, require withholding payroll taxes. For executives or other large grants, a failure to withhold could create a material liability for the company. ISOs, on the other hand, do not require payroll withholding if handled properly, but, for example, cannot be exercised after 3 months from the last day of employment, and after such date would then be taxed as an NSO. Some companies get tripped up by 83(b) election issues, which must be made by the participant within 30 days of grant – otherwise the grant may lose its tax-favored status. Collectively, these tax issues often involve a greater level of education among award recipients so that they don't miss filing deadlines or experience unwelcome and unexpected tax bills. In addition, there are plenty of stories of failures on the part of companies related to tax issues, in which the corporation ends up footing the bill for participants in order to save face.

Also, watch out for corporate filing deadlines regarding ISO exercises. By January 31, you need to provide employees information statements about their ISO exercises in the preceding year, and you must file Form 3921 with the U.S. Internal Revenue Service by March 31 (if electronic). This form provides employees and the government information for Alternative Minimum Tax (AMT) calculations, but it is recommended to alert your employees about this issue and the fact that their gains could potentially trigger the Alternative Minimum Tax.


The best practice is to create a separate equity plan for each country (or, at minimum, region). That's because there are differing legal requirements and differences in tax favorability from country to country. In fact, the same award in the U.S. could create a significant tax or legal burden to a recipient in another country, or may not even be allowed. For instance, in China, private companies are forbidden from issuing equity to their employees unless the future vesting is based on being a public company. Your local payroll processor may be able to offer some assistance (particularly with respect to tax withholdings), but they may not have deep expertise regarding equity compensation. It is also recommended to seek legal guidance when issuing equity in a new country.


Private companies are renowned for their lean operations, which often means that the teams administering equity plans wear many hats and have many other day-to-day responsibilities. However, that hard reality doesn't eliminate the unyielding requirement to plan this crucial component of your compensation strategy.

Start by ensuring you have a clear picture of where your company expects and intends to be in the next six months, two years, and five years and use that perspective to tailor your decisions regarding your equity plan. Are you issuing the right kinds of options and grants that align best with your goals? Although most startups don't like to think about people quitting, getting terminal illnesses, or dying unexpectedly, you do need effective termination procedures in place.

What happens during an IPO? Will your technology platform handle the transition? You want to easily step up to the new reporting requirements, leverage the system to help prepare your S-1, and be able to work with your preferred broker. In addition, you should consider what types of grants you will want to award post-IPO.

Some careful planning ahead of time can keep you out of dead-end choices and give you the latitude you need to adapt as your business grows.


For private companies, managing equity plans requires a careful blend of strategy and technology, as well as an in-depth understanding of the nuances and complexities of equity compensation. Before embarking on a path that can lead to a dead end, make sure you consider where you plan to be in the next two or five years. Establish the right communications channels and define repeatable processes up front. As you seek to bring a level of structured automation to the discipline, be wary of the pitfalls of simple spreadsheets. Get informed on the implications of making modifications to grants and of offering equity internationally.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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