Why do startups prefer Stock Options over Stock Grants?

Short Answer

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Why do startups prefer Stock Options over Stock Grants?

An incentive stock option is the only way to defer taxation of a stock grant or stock options until the employee-shareholder has cash in hand that has been realized from that stock grant or stock option. So, it aligns an employee's incentives with the company's profits without becoming a tax albatross.

Why do large companies alike seem to always prefer to offer their employees stock options, rather than stock grants?

So that senior employees can convert income that would otherwise be taxed as ordinary income in the form of wages and salaries into capital gains which are taxed at a lower rate.

In large companies, this consideration tends to overwhelm the fact that stock grants are a better incentive for the company than stock options, because stock grants carry both downside risks and upside opportunities, while stock options are a heads I win, tails you lose proposition for the company that grants them, encouraging excessive risk taking and inviting senior employees to discount serious risks of losses to the company. The skewed set of incentives created by stock options in large corporations for key employees was one of several important drivers of bad decision making that led to the financial crisis of 2008.

Long Answer

The primary reason is that there are safe harbor tax benefits for stock options under Section 421 of the Internal Revenue Code for Incentive Stock Options (ISOs) that do not apply to stock grants. The employee does not realize gain or loss when the option that meets the requirements of the section is granted or exercised. Instead, the employee realizes gain or loss when the stock purchased pursuant to the option is sold. This gain is a long term capital gain if the stock is sold at least two years after the option was granted and at least one year after the option was exercised. The gain is the difference between the sale price and the exercise price (is the stock is not held for a year after exercise the built in gain at the time of exercise is ordinary income and the remainder is a capital gain). No more than $100,000 of ISOs may be exercised in any one year.

Almost no one gets stock options that don't fit the rules for an ISO on purpose, that usually happens instead because of legal or accounting malpractice by the person who set up the plan.

In the case of stock grants the usual choice would be a qualified equity grant under Section 83(i) of the Internal Revenue Code (which defers income on a grant of non-transferrable stock until it is possible to sell), rather than a stock grant under Section 83(b) which almost never happens and would be challenging and expensive to value in a closely held start up company.

But a Section 83(i) qualified stock grant still forces to employee-shareholder to pay income tax on the stock when it is possible to sell, rather than when it is actually sold, so the employee-shareholder has to sell the shares immediately or face taxation without liquidity which most employees aren't interested in risking. A start up founder generally doesn't want employees worthy of stock grants selling their shares as soon as it is possible to do so in order to provide liquidity to pay taxes.

The example given illustrates a key misunderstanding of the situation:

Stock grant: year-1, give an employee $10k in stock grnats, subject to vesting. After year-4, let's suppose that $10k is now worth $100k. At the beginning (year 1) you'd do an 89(b) election [ed. actually 83(b)], pay ordinary income taxes on the $10k worth of stock granted, and then at the end of 4 years the employee would own $100k worth of shares, with no tax obligation.

Stock options: year-1, give an employee $10k in stock options, subject to vesting. After year-4, let's suppose that $10k is now worth $100k. Now, when the employee exercises these options at the end of year-4, they'll owe ordinary income on $100k, in addition to having to pay the company $10k to purchase the shares. Unless the employee can obtain immediate liquidity by selling half of those $100k in shares, they'll be screwed. Seems like an awful deal compared to the above.

One of the key things to recognize is that nobody gives anyone $10K of stock options or $10K of stock. Part of the reason that employees of startups are paid "in kind" is that nobody really knows what the shares of a closely held start up company are worth, and certainly, nobody is interested in paying taxes to the IRS and state income taxing authorities on phantom income that can't be turned into consumption from a stock grant for stock with a nominal price of $10K that has a high probability of becoming worthless, rather than producing a profit or even a break even outcome, and if it does, would only do so much later. How often do they fail?

In 2019, the failure rate of startups was around 90%.

Employees are not interested in paying taxes on two birds in the bush when they don't actually have one in hand, just a hunting license to try to get a couple of them. They know that most stock options never give rise to any money.

Also, stock purchases or grants give rise to an obligation to make dividend distributions to the employee-shareholder (if any are made), a right to vote as a shareholder, and a right to obtain information about the company's finances, while those rights and obligations don't arise with respect to a stock option until the option is exercised.

If the company is taxed as an S-corporation (which it usually will be until it goes public to avoid double taxation at the corporate and shareholder levels, although this incentive is somewhat less compelling after the 2017 tax law change of closely held and corporate entity taxation), the employee will also have to pay tax on "phantom income" from ownership of the shares, whether or not any dividends are actually paid (and in a start up it would be common for no dividends to be paid).

But generally, stock options in start up companies are only exercised when the stock has become liquid for some reason, so that the options can be exercised "immaculately" if desired (converting the options into cash by exercising the option at an option price that is less than the currently available cash price and pocketing the difference) and paying ordinary income, or can be exercised (often with borrowed money) so that it can be held for another year and taxed at capital gains tax rates instead (if the employee has enough confidence that the start up company will have retained its value a year after the option is exercised).

When there is a desire to have employees incentivized to make a closely held company profitable, it would also be common to organize the company as an LLC, possibly with a profit interest rather than as a corporation to which stock grants and stock option treatment applies.