Incentive Units vs. Stock Options

The competitive job market has prompted many companies to offer incentives to their employees in order to retain them. Of course, it is not easy for companies to retain experienced workers, so one effective to keep them is to provide them with attractive perks such as incentive units and stock options.

Incentive units represent ownership stakes in a company, granting the holder a percentage of ownership, whereas stock options provide employees the right to purchase a specific number of shares at a predetermined price within a certain period.

If you are considering an equity compensation plan such as incentive units or stock options, it is important to understand their key differences. In this article, we will delve deeper into the pros and cons of each of these forms of compensation so that you can make an informed decision about which one is right for you.

While incentive units and stock options are used for the same purpose, they differ in several ways. For example, incentive units are typically granted to key employees and executives, while stock options are more commonly used for all employees.

Let’s go into the details of both:

What are incentive units?

A limited liability company (LLC) may offer incentive units as equity compensation to its service providers, including employees, managers, and consultants.

These units represent a share or ownership interest in the company and are used to align the interests of the service providers with those of the company’s owners. Unlike stock options or common shares in a corporation, incentive units are commonly utilized in LLCs due to their flexible structure.

Here’s how incentive units work:

Granting Incentive Units: The company establishes an Incentive Unit Plan, specifying the rules and procedures for granting incentive units. The plan outlines the eligibility criteria, the number of units to be granted, and any vesting schedules.
Documentation: To implement the plan, the company creates an Incentive Plan Document, a form of Award Agreement, and may need to amend its operating agreement or similar document.
Authorization: Managers and members of the LLC (if applicable) authorize the adoption of the Incentive Unit Plan, the size of the incentive unit pool, and any related documents.
Issuance of Incentive Units: Incentive units are then issued to eligible service providers. These units represent a share of ownership in the company.
Vesting: Incentive units may be subject to vesting schedules, meaning that the service providers earn ownership rights over some time or upon achieving specific performance milestones.
Rights and Privileges: Incentive units often have specific voting and financial rights. The company’s operating agreement specifies the nature of these rights, which may differ from those of other classes of membership units.
Valuation and Benefits: The value of the incentive units is tied to the company’s overall valuation. If there is an increase in the company’s value, the value of the incentive units held by the service providers will also increase. When the incentive units are sold or the company goes through an exit event (such as a merger or acquisition), the holders of incentive units receive a share of the proceeds.
Termination or Transfer: Incentive units may be subject to certain conditions upon termination of employment or other events, and there may be provisions for the transfer or sale of units.

What are stock options?

Stock options are financial instruments that offer employees the right, but not the obligation, to buy or sell a specific number of shares of a company’s stock at a predetermined price (the exercise or strike price) within a specified period.

They are commonly used as a form of employee compensation, aligning the interests of employees with the company’s performance and stock value.

Here’s how stock options work:

Granting of Stock Options: Companies grant stock options to employees as part of their overall compensation package. The option grant notice specifies the number of options granted, the exercise price, and the vesting schedule. Employees have the choice to either exercise their options or decide not to do so.
Vesting Period: Stock options often have a vesting period, during which the options are not immediately exercisable. Vesting encourages employee retention and performance over time.
Exercise Price: The exercise price is the predetermined cost at which the option holder can buy the company’s stock when they choose to exercise their options. This price is typically set at the stock’s fair market value on the grant date.
Expiration Date: Stock options have an expiration date, after which they can no longer be exercised. This period is usually a few years after the grant date.
Exercising Options: When an employee decides to exercise the stock options, they purchase the specified number of shares at the predetermined exercise price. The difference between the current market price of the stock and the exercise price is known as the “spread.”
Tax Implications: The tax treatment of stock options depends on the option type granted. Incentive stock options (ISOs) and non-qualified stock options (NQSOs) have different tax implications. Generally, employees are not taxed when options are granted but may face taxes upon the exercise or sale of the acquired shares.
Use of Proceeds: Employees may hold or sell the shares after exercising stock options. The decision depends on market conditions, personal financial goals, and tax considerations.
Stock Price Movement: The company’s stock price movement impacts the stock options’ value. The options become more valuable if the stock price rises above the exercise price.
Forfeiture or Termination: Employees may forfeit unvested options if they leave the company before the options are fully vested. Some stock option plans have provisions for post-termination exercise, allowing employees to exercise options under certain conditions after leaving the company.

Differences between Incentive Units and Stock Options

Now, let’s compare incentive units and stock options side-by-side.

Feature	Incentive Units	Stock Options
Nature of Instrument	Ownership interest in a limited liability company (LLC).	It gives the right to buy or sell shares in a Corporation (C-Corp) at a specified price within a certain period.
Type of Entity	Typically used in LLCs.	Commonly used in corporations.
Granting Entity	LLC grants membership units.	The corporation grants options.
Eligibility	A broad range, including employees, managers, and consultants.	Primarily employees, executives, and sometimes consultants.
Vesting	Yes, it is often subject to a vesting schedule.	Yes, it is typically subject to a vesting schedule.
Exercise Price	No exercise price; represents ownership in the LLC.	Set exercise price, representing the cost to buy shares.
Tax Implications	Generally taxed as capital gains upon sale.	Tax treatment depends on the type (ISOs or NQSOs), including potential tax at exercise and capital gains tax at sale.
Expiration Date	There is no expiration until the sale or exit event.	Has an expiration date, usually several years after the grant date. Options expire if not exercised by then.
Entity Valuation Impact	Influenced by the overall value of the LLC.	Influenced by the stock price of the corporation.
Transferability	Subject to restrictions specified in the LLC’s operating agreement.	Often not transferable or with limitations.
Rights and Privileges	May have distinct voting and financial rights as specified in the operating agreement.	Typically, no voting or financial rights are exercised or owned.
Termination or Transfer upon Leaving Co.	Treatment depends on the LLC’s operating agreement.	Vested options may be exercised within a specified period post-employment. Unvested options may be forfeited.
Definition	A form of compensation in LLCs, representing a right to profits and value increase, but not an ownership interest.	Offers from a company to buy a specific number of shares at a fixed price after a waiting period.
Ownership	Do not always confer ownership or voting rights in the company.	Provide potential ownership in the company once exercised.
Ideal Usage	It is suitable for LLCs or non-corporate structures and aligns with company performance.	Common in corporations, especially public ones; used to retain/attract employees.
Risk and Reward	Lower risk; no upfront investment; reward tied to profitability.	Higher risk; requires investment, high reward if stock value increases.
Liquidity Events	May receive cash/share distributions during liquidity events, based on the operating agreement.	Can sell shares after exercising, typically post-public offering or acquisition.

Tax Implications of Incentive Units

Incentive units, commonly used in LLCs, provide ownership interests to service providers without immediate tax consequences upon grant or vesting. Taxation is deferred until sale, treated as capital gains (short-term or long-term) with favorable rates.

In LLCs, recipients may be subject to pass-through taxation, where business profits and losses pass directly to owners, who report them on their personal tax returns. Alternative Minimum Tax (AMT) may apply upon exercise. AMT is a separate tax system ensuring that high-income taxpayers pay a minimum tax, regardless of deductions or exemptions. Professional tax advice is crucial due to the complexity of tax laws, varying state regulations, and potential implications for individual circumstances.

Tax Implications of Stock Options

Stock options entail specific tax considerations. No tax at grant, potential ordinary income tax at Non-Qualified Stock Options (NQSO) exercise, and possible AMT for Incentive Stock Options (ISO). The holding period affects capital gains or losses upon share sale.

Employers may withhold taxes andstate and local tax variations exist. Professional tax advice is important for navigating complex tax rules, ensuring compliance, and optimizing financial outcomes.

Which is better: incentive units or stock options?

There is no decisive answer on which is better between incentive units and stock options, as the choice depends on the company’s structure, goals, and the preferences of both the company and its employees.

LLCs typically use incentive units, offering ownership with potential tax advantages. Stock options are more common in corporations, providing flexibility but varying tax implications.

Conclusion

While incentive units and stock options target the same thing, which is a form of compensation, they differ in many aspects. With incentive units, employees do not need to pay anything to own them, but to exercise stock options, employees have to pay. Also, incentive units are typically used by LLCs, while stock options are offered by corporations.

Incentive Units vs. Stock Options