Why Crypto Might Be the Next Big Thing in Compensation

All companies have competition. It could be for market share, investors, or other key resources, but talent is one of the most significant. Top-tiered talent is a key differentiator that can make or break a business. The best employees will design better products, provide superior service, close more and bigger deals, or develop strategies that can help a company not only survive but thrive in both good times or difficult times.

To retain, attract or motivate key people, many companies offer non-cash incentives like stock options. While these traditional equity incentives are still critical parts of the recruitment and retention process, technology continually introduces change. Now, a small, but growing number of forward-thinking companies have started using cryptocurrency and digital assets as part of their incentive and compensation packages.

For employees of digital assets and blockchain companies, this could see them getting paid in tokens instead of cash. Many tokens have a liquidity advantage over equity awards. As long as there are no restrictions on the property and a marketplace (i.e., an exchange) exists with sufficient trading volume, the tokens can potentially be sold quickly as compared to a potential long-time horizon for private company equity awards.

How traditional stock options function

Most companies that offer traditional stock option incentives have developed a program that issues the employee the right to buy shares at a set price. There is usually a routine vesting period (ranging from one to three years or longer) before the option-holders fully lock in their options or can exercise their shares. During this period, the company share price could rise above the option prices, giving the employee a chance for 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 beneficial in ensuring higher retention rates over competitors, or simply to keep up in a competitive marketplace. There is one wrinkle though: Under standard 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 vital that companies consistently assess their equity value to facilitate these plans.

The benefits of token-based options

The past decade has seen an explosion in the growth, popularity and use of cryptocurrencies and digital assets. There have been countless news stories about fortunes made or just buzz for well-known tokens like Bitcoin and Ethereum hitting record highs. Large companies like Tesla and AT&T accept crypto as payment options. A growing number of countries are looking at developing their own cryptocurrency, while El Salvador has become the first country to accept crypto as legal tender.

Not surprisingly, a growing number of companies have started to offer digital assets as part of compensation and incentive packages, even organizations that are not engaged in crypto-related business. There are many reasons for this, but often employees find them desirable because there is a chance the digital assets could significantly increase in value. There are further advantages for both the company and its employees. For a business, giving tokens does not dilute the company’s capitalization table. Plus, companies can still require a vesting period where the employee cannot access the tokens for a set period, similar to stock options. And, as cryptocurrency valuations grow, this could provide a more significant incentive to stay.

Compensation with tokens

Recipients of tokens are often allowed to sell the tokens immediately. Many crypto startups award newly issued or outstanding tokens for services (current or future). If there is no restriction 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 become more popular over the past several years. They operate similarly to restricted stock awards since restricted tokens generally are subject to vesting based on continued service or achievement of performance targets and can be subject to accelerated vesting (subject to predetermined triggers). Some reasons the vesting period could be shortened include the termination of the employee without cause, a change in control transaction, or achieving a technical milestone for the token platform. Restricted token recipients are taxed based on the spread, which is the difference between the fair market value at the time of vesting and the amount paid by the recipient for the tokens.

There is another option that founders and employees can make when it comes to restricted tokens awards. They can opt to make a Section 83(b) election, which would see them pay taxes on the fair market value of the tokens at the time of the grant rather than at the time of the sale. Individuals have a thirty-day window to make this choice once they receive the tokens.

However, there is a risk with this choice. 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 before full vesting, the prepaid tax on value above actual economic gain from the token will not be recoverable. Unfortunately, undoing the 83(b) election can also be problematic, if not impossible.

For these reasons, restricted token awards require significant tax planning, including important valuation considerations.

Token options and restricted token units

Some digital asset and blockchain entities have implemented token option plans, which are comparable to stock options. Token-based awards mimic traditional equity-based awards and are tied to specific requirements that must be met during the vesting period. The tax treatment of the token options depends on the relevant tax jurisdictions.

For many startup digital asset and blockchain companies, tokens are an important value proposition. If structured as compensation, or as token-based awards, they provide immediate or long-term liquidity for employees, cash flow relief for new startups, and generally do not dilute the company’s ownership.

For income tax purposes, restricted tokens are viewed comparably to restricted stock units. When granted, the employer promises to issue the recipient a certain number of tokens in the future. This promise is tied to specific conditions during the vesting period. The recipient only becomes the legal owner after the vesting period with restricted token units, 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.

Cryptocurrencies started with lots of nascent enthusiasm but limited value. In the past decade, they have become legitimate assets that can be bought, sold, traded and redeemed. Even sovereign countries are using them as legal tender. They have become desirable incentives for employees, and the discount from restriction periods can benefit tax optimization. Regardless of which type of incentive a company chooses to give its employees, it is essential that organizations contact valuation and tax professionals to ensure a proper defense of any adjusted market values or discounts, so there are no surprises from taxing authorities.