Equity compensation is an effective way to attract and retain talent without materially reducing a company’s cash flow. That said, noncompliance with local laws could end up costing a company in the long run.

In addition to making equity grants to its employees, it is common―particularly for early-stage companies―to grant equity awards to service providers who are not direct employees of the company or an affiliate, such as independent contractors or “agency workers,” who are employed by an employer of record (“EOR”) or professional employment organization (“PEO”). These types of arrangements have an inherent risk of reclassification, de facto employment and co-employment that is only further increased by granting equity awards.

While it is generally not recommended to grant equity awards to these service providers due to the employment law-related risks, if other factors (e.g., talent retention) outweigh the employment-law risks, from a corporate governance perspective, it is important that you first assess the feasibility of making equity grants to service providers and understand whether doing so will trigger filing requirements or tax reporting/withholding obligations.

Questions to Consider Before Granting Equity to Non-Employees

1. Does the plan allow for making grants to service providers who are not employees of the company?

While this is more of a U.S. plan issue, first confirm whether the equity plan allows the company to grant equity to service providers. If not, then the company may need to restate the plan to allow these service providers to be eligible to participate.

2. Do securities regulations and/or foreign exchange requirements apply to the proposed equity awards?

Securities Regulations: There may be an obligation for the company to complete a filing with the securities regulators in the jurisdiction where the service providers are located or perhaps provide the service providers with a prospectus or some other document (in addition to the plan and applicable award agreement).

The good news is that in many jurisdictions, the company will be exempt from securities-law obligations if it limits grants to a specific number of participants below the country-specific threshold (referred to in many countries as a small offer exemption).

However, in some in jurisdictions, companies often rely on an employee exemption (e.g., an exemption for equity grants made to employees) to the prospectus or securities filing obligation where the exemption may not apply to folks that are not direct employees of the company or an affiliate. This is generally found to be true in jurisdictions such as Canada and Singapore, where the employee exemption is generally not applicable to employees of a third-party PEO or EOR. That said, there may be other exemptions that could apply and that your company should consider before deciding whether to move forward with the grant.

Foreign Exchange: In many countries, the foreign exchange and/or ownership rules equally apply to employees and other service providers. That said, in some places, such as China, India and Morocco, the type of service provider could impact the feasibility of that person sending money overseas to acquire shares of the company and could affect the feasibility of making grants or practically affect the service providers’ ability to access their shares due to foreign exchange restrictions.

3. What are the company’s potential tax obligations?

While most jurisdictions tax an employee at the time of acquiring the underlying shares from the award, for example, upon exercising a stock option or settling an RSU vest, timing of taxation for service providers may differ. In some cases, it may be accelerated to the grant date or deferred until the subsequent sale of shares, depending on relevant case law or practice. In other instances, the timing of taxation may align with the timing of taxation for employees.

This becomes particularly important where the company (as the issuer) has tax reporting and/or withholding obligations related to the grants made to these service providers with which it must comply.

Even where the company does not have an explicit obligation (e.g., where equity is granted to service providers that are employed by a third-party EOR or PEO), the company should generally be aware of the tax reporting and/or withholding obligations, as the company could be held jointly and/or severally liable for any noncompliance on the part of the EOR/PEO.

In sum, there are important questions to consider when granting equity to service providers outside the United States in order to manage and assess relevant risks for your company.