Many companies give incentive stock options as part of their compensation packages. But as crypto tokens grow in popularity, is the tide turning to a new incentive path?
By Kemp Moyer, Director, Advisory
Successful businesses across the United States are highly cognizant of the importance of attracting and retaining top talent. Not only does top talent help businesses deliver superior services and products, but it can also mean the difference between surviving and thriving. Many companies attract, retain and motivate key people by providing non-cash incentives like stock options. These equity incentives remain a key part of the recruitment and retention process. However, as technology continues to change the face of business, some forward-thinking companies have started using cryptocurrency tokens as part of their incentive and compensation packages.
Namely, employees of digital assets and blockchain companies could get paid in tokens instead of cash. Many tokens have a liquidity advantage over equity awards. That is because tokens can be immediately sold upon receipt assuming that no restrictions have been placed on the receipt of property and that a marketplace (i.e., an exchange) exists to sell the tokens with sufficient trading volume.
How Incentive Stock Options Work
With traditional incentive stock options, the company develops a program to issue the employee options to buy shares at a set price. Typically there is a vesting period (ranging from one to three years or longer) before option-holders fully lock in their options and/or can exercise into shares. During the vesting period, the price of shares could rise above the employee's option price and represent significant gains. Readers will likely have heard numerous tales of early employees cashing in their stock options at successful growth companies for a major windfall.
Within the structure of options grants, the primary reason for vesting periods is to ensure the employee stays with the organization. That, along with the aligned incentive of ownership provides a dual value. With savvy management, this process can be very helpful in ensuring higher retention rates as compared to peer companies. There is one wrinkle though: Under normal options plans, the employee must pay tax on the price difference between their option price and the sale price at the time of the exercise. As a result, it is important that companies assess their equity value consistently in order to facilitate these plans.
Understanding Token-Based Awards
Meanwhile, cryptocurrencies have seen a surge in popularity, use and news coverage over the past decade, with buzz often associated with tokens like Bitcoin or Ethereum hitting record highs. Even big-name companies like Tesla and AT&T accept crypto as a payment option.
It should not come as too much of a surprise, then, that companies not even engaged in crypto-related business are offering cryptocurrency tokens as part of compensation and incentive packages. For one, employees find them attractive because there is a chance the tokens could significantly increase in value. But using crypto tokens for incentives can have further advantages for both the employee and the company. Notably, giving cryptocurrency tokens does not dilute the company's capitalization table. Moreover, companies can still require a vesting period where the employee cannot access the tokens for a set period, just like stock options. In a rising token valuation environment, this might provide a more significant incentive to stay than even company stock.
Tokens as Compensation
Token awards generally allow recipients to have access to tokens immediately. Many startups award newly issued or outstanding tokens for services (current or future). If no restrictions are placed on the receipt of the tokens, these awards are generally taxable when actually or constructively received, subject to income tax withholding obligations.
Restricted tokens have gained significant popularity over the past several years. Similar to restricted stock awards, restricted tokens are generally subject to vesting based on continued service or achievement of performance targets and can be subject to accelerated vesting (subject to predetermined triggers). The triggers may include a change of control transaction, the termination of an employee without cause, or achievement of technical milestones for the token platform. The recipient of the restricted token award is generally taxed on the spread — that is, the difference between the fair market value at the time of vesting and the amount paid by the recipient for the tokens.
Often the founders and employees consider making Section 83(b) election with respect to the restricted token awards within thirty days of receiving the restricted tokens. When making this election, the recipient pays tax based on the spread of all awarded tokens at the time of grant rather than the time of sale
If the tokens ultimately decrease in value as they vest compared to their value on the date of grant, or if all or a portion of the tokens are forfeited because the recipient’s service terminates prior to full vesting, the prepaid tax on value in excess of actual economic gain from the tokens will not be recoverable. Unfortunately, undoing the 83(b) election can also be problematic if not impossible.
All said, restricted token awards require significant tax planning, including significant valuation considerations.
Token Options and Restricted Token Units
Some digital asset and blockchain entities have implemented token option plans which are analogous to stock options. Token-based awards mimic so called traditional equity-based awards and are tied to certain requirements which need to be met during the vesting period. The tax treatment of the token options depends on the relevant tax jurisdictions.
Tokens provide an important value proposition for startup digital asset and blockchain companies because tokens, if structured as compensation or as token-based awards, provide immediate or long-term liquidity for employees, cash flow relief for new start-ups, and generally do not dilute the owners of the Company.
Restricted token units are also very similar to restricted stock units in the way they are treated for income tax purposes. Generally, at grant the employer promises to issue the recipient a certain number of tokens in the future, which are tied to certain requirements during the vesting period. With restricted token units, the recipient only becomes the legal owner at vest, which is generally a taxable event.
As with restricted token awards, significant tax planning, valuation and legal considerations should be given to token options and restricted token units.
Considering Offering Tokens as Compensation or Incentive? Let BPM Be Your Guide.
Cryptocurrencies have gained much legitimacy over the past decade. These digital assets can be a desirable incentive to employees, and the discount from restriction periods can provide a tax optimization. Regardless of which type of incentive a company chooses to give its employees, organizations should contact a valuation professional to ensure proper defense of any adjusted market values or discounts, so there are no surprises from the taxing authorities.
BPM provides the technical advice you need to thrive and navigate through the rapidly changing regulatory landscape of token-based compensation and all matters crypto/blockchain. The professionals in our dedicated Blockchain and Digital Assets Industry Group have extensive knowledge and experience in dealing with tax, accounting and auditing matters, as well as regulatory and compliance issues, including revenue recognition, IT compliance, enterprise risk management, and classification and valuation of digital assets. To learn more about how BPM can assist with your business’s crypto needs, contact Kemp Moyer, Director in our Advisory practice, today.
