This article was originally published by Jeron Paul, founder of Capshare (now Shareworks by Morgan Stanley).
Today’s startup companies may not know it, but they owe a lot to the Illinois Central Railroad Company chartered in 1851. Business historians think it was the first company to create an employee equity incentive plan.
In May 1893, the Illinois Central Railroad Company offered its employees the ability to buy stock in installments. The Massachusetts Labor Bulletin of 1901 said:
At the time… [Illinois Central] stock was selling well under par and the employees who subscribed at the terms offered secured a very advantageous investment, for Illinois Central stock is now quoted at close to 130. Employees all along the company’s line have one or two share lots of the stock and the management believes the plan has done much to interest the general body of employees in the success of the company.
We often think that tech companies pioneered broad-based employee equity plans. But companies were doing it back in the late 1800s.
We have come a long way since then. Now, almost all companies compensate at least a portion of their employees with equity incentives. Companies seek to align the interest of their employees with that of the stockholders by making stockholders out of their employees.
Most private company CFOs are familiar with stock options (ISOs and NSOs). And in the private sector, stock options have worked well for years. But what other alternatives are there? Have there been any big innovations?
Bill Gates preferred stock and RSUs at Microsoft:
When you win [with options], you win the lottery. And when you don’t win, you still want it. The fact is that the variation in the value of an option is just too great. I can imagine an employee going home at night and considering two wildly different possibilities with his compensation program. Either he can buy six summer homes or no summer homes. Either he can send his kids to college 50 times, or no times. The variation is huge; much greater than most employees have an appetite for. And so as soon as they saw that options could go both ways, we proposed an economic equivalent. So what we do now is give shares, not options.
But can they work well for private companies? Also, why not just stick with stock options?
A traditional RSU has pros and cons relative to standard stock options. But you can structure RSUs for your private company where they have almost all of the benefits of stock options and only one real drawback.
John, my co-author, figured out how to do this with his attorneys. John and I met when John was looking for a cap table solution for Blueleaf, his rapidly-expanding software company for financial advisors.
On our initial call, John mentioned that he had given many of his key employees RSUs instead of options. When I asked why, he said that if you structure RSUs properly, they can be a better employee equity instrument than ISOs. I was intrigued enough to ask for more information and I am glad I did.
Let’s start by understanding the different kinds of equity instruments. Feel free to skip to the end of the article if you just want to know how John structured his company’s RSUs.
Also, sign up here if you want to use Shareworks Startup Edition to help you manage your RSU program.
A Primer on Equity Compensation
Disclaimer: This article provides only a high-level overview on RSUs and Options including some tax information. Before setting up a plan, you may want to consult with your lawyer and/or a qualified tax advisor. Providing this information does not constitute legal or tax advice.
Over time, the number of equity incentive instruments has increased. More choices means more complexity, but it also means having a greater number of useful tools. Here are the most common instruments:
- Stock Options (ISOs and NSOs)
- Restricted Stock
- Restricted Stock Units (RSUs)
- Stock Appreciation Rights (SARs)
- Phantom Stock
- Profits Interests
Stock options represent the right to buy a company’s stock at some future date at a price established now. The future value of high-growth companies can exceed current values by large amounts. So stock options can become worth a lot. Upon exercise, the holder becomes an official company shareholder.
Restricted stock is stock with restrictions for which payment is not usually required. Most of the time, it is simply common stock that vests. The holder of restricted stock cannot sell their shares until they vest. Additionally, a company typically retains the right to repurchase all unvested shares upon the termination of the holder’s employment. Restricted stock holders are official company shareholders.
Restricted stock units are a commitment to give the value of a specific number of the company’s shares in the future for which payment is not usually required. Generally, certain conditions, such as vesting, must occur before the holder of RSUs can receive the promised value. Settlement of RSUs can occur in stock or the equivalent cash value of the company’s stock. If an RSU recipient receives stock, they become an official company shareholder.
Stock appreciation rights are cash or stock bonuses tied to the performance of a company’s stock over a certain period. The holder of stock appreciation rights (SARs) does not own stock and is not a stockholder.
Phantom stock is a cash or stock bonus that replicates owning a company’s stock over a certain period. But phantom stock is not technically stock, and so again, the holder is not a stockholder.
Profits interests are a claim to the increase in value of an LLC over a period of time. They are only available to LLCs.
Public companies use a wide variety of these tools. Private c-corps have typically only used stock options and restricted stock.
In this article, we are just going to focus on comparing stock options and RSUs.
Why Private Companies Use Stock Options
Stock options have become the standard at private companies for two primary reasons:
- Upside potential, and
- Potential tax advantages
Upside Potential of Stock Options
Stock options incent employees to increase the value of the company. If your company’s value decreases, stock options lose most of their value. So they only create wealth for your employees if your company’s value increases.
This is because options have a strike price. The strike price is what it costs to exercise an option into a share. This is why the strike price is also commonly referred to as the exercise price. You cannot sell an option legally. So to convert an option into something valuable, you have to exercise it.
Strike prices are expressed in dollars per share. Let’s assume Mary has an option grant for 10,000 shares at a $0.10 strike price. She would need to pay $1,000 (10,000 * $0.10) to exercise all of her options.
This turns her 10,000 options into 10,000 shares of common stock. She can now sell her stock for a monetary gain.
But there is a wrinkle. What if Mary can only sell her common stock for $0.05 / share? She would pay $1,000 to convert her options to common and then sell her common stock for $500. This doesn’t make sense.
So Mary will only exercise her shares if she thinks she can sell common stock for more than $0.10 / share.
This diagram shows the payout to Mary at different values of common stock.
If the common stock is worth $0.25 / share, Mary will turn a profit of $1,500 upon the sale of her 1,000 shares. If the common stock is worth $0.05, Mary won’t exercise and her payout is $0. If the common stock is worth $5.00, Mary’s payout is $49,000.
The intrinsic value of an option is the current value of the underlying stock less the option’s strike price. If the intrinsic value of an option is greater than zero, it is in-the-money. This happens when its strike price is less than the per-share value of common. If the intrinsic value of an option is zero, it is called out-of-the-money. This happens when its strike price is greater than or equal to the per-share value of common.
Tax Advantages of Options
Most private companies granting options to employees use ISOs (Incentive Stock Options). ISOs have some great tax benefits!
Typically the US government taxes vesting securities, such as restricted stock, as they vest. This can create problems for employees–especially at startups. Employees may not have the cash available to pay the taxes. The typical startup employee won’t be able to sell a portion of his or her illiquid stock to cover the taxes.
Options are different. The holder of an option (whether it be an NSO or ISO) does not pay any tax as the option vests, and an optionee that never exercises their options will never pay tax. NSOs get taxed on the date of exercise. ISOs are even better; with an ISO, there is no tax obligation until the underlying security (stock) is sold.
Although there are no taxes due upon exercise of on an ISO for regular tax purposes, the gain upon exercise will counted toward one’s Alternative Minimum Tax (AMT) calculation. You should seek the guidance of a qualified tax professional whenever exercising options.
Let’s use the example of Mary again. Let’s say her options are ISOs and she exercises by paying $1,000 (10,000 * $0.10). Then, 366 days later, she sells her stock for $5.00 / share. What will her tax be?
Because Mary exercised her shares more than 12 months ago, she qualifies for the long-term capital gains rate. Let’s assume it’s 20%.
Mary will pay 20% * (10,000 * ($5.00 – $0.10)) = $9,800 in taxes. So she will pay a total of $9,800 in taxes on equity worth $49,000 (10,000 * ($5.00 – $0.10)). She pockets $39,200.
This is a great benefit of ISOs – they can help employees reduce their tax obligation. Mary was taxed at the long-term capital gains rate on 100% of her realized gain.
Unfortunately, most holders of ISOs don’t end up paying taxes at the long-term capital gains rate. Most employees wait until the company is sold to exercise their options (a same-day sale). In one day, they both exercise their options for shares and sell those shares to the purchaser of the company. This disqualifies them from receiving long-term capital gains tax treatment. They are instead taxed at the short-term capital gains rate, which is equivalent to their ordinary income tax rate.
What would happen if Mary did not exercise until the company sells? Upon sale of the stock, Mary would pay taxes at the ordinary income tax rate. She would pay 35% * (10,000 * ($5.00 – $0.10)) = $17,150.
You may have noticed that Mary paid an extra $7,350 (or 75% more) in taxes when she did not receive long-term capital gains treatment. These tax saving can be realized by all employees, even if their options have not vested, as long as they have the choice to early exercise their options. There are some risks though. Read our discussion of early exercise here.
In conclusion, the upside potential and tax treatment of options, especially ISOs, have made them popular with high-growth private companies. However, most employees don’t end up receiving the best possible tax treatment that is available with stock options.
Problems with Stock Options
Stock options have worked great for private companies for years. But there are some drawbacks. For one thing, their biggest strength is also their weakness. If the value of a company’s common stock drops below the strike price, the options will become practically worthless.
Now, you may only want your employee’s options to have value in big upside scenarios. After all, the point is to incent them to help the company grow. But what if your company’s valuation is too high? Or what if your company’s value fluctuates at the time you grant options but you still get a good exit?
These scenarios can lead to employees with out-of-the-money options. Most of the time, these scenarios require re-issuing options to employees to keep them motivated. Re-issuing stock options is painful and costly.
Stock options turn your employees into official shareholders once they exercise. And they have a legal right to exercise their shares as soon as their shares vest. So granting options will almost guarantee the increase of your shareholder base, and shareholders come with a bunch of baggage.
For example, in the U.S. your company can only have 500 non-accredited shareholders before it must file to go public. Many successful companies exceed this threshold before they IPO. This is one reason why Facebook stopped issuing options.
Shareholders also have voting and information rights. You may not want to have to disclose sensitive company information to a disgruntled employee who exercises options on their way out the door.
For private companies, granting stock options will also require a 409A valuation. 409A valuations are a costly compliance hassle.
So many private company CEOs and CFOs have looked for alternative compensation tools. Restricted Stock Units seem like a natural fit because they are quite similar to options.
Pros and Cons of Restricted Stock Units (RSUs)
Restricted Stock Units (RSUs) are a company’s promise to give shares or cash to an employee in the future. RSUs are often subject to vesting. Employees with vested RSUs have to wait for the vesting to get cash or stock.
It is common to vest RSUs over time just like options. You can also vest RSUs using milestone triggers like achieving a certain amount of revenue or even the sale of the company.
RSUs do not have a strike price. This means that they will have some value as long as common stock has value. This can be a huge benefit for employees. Even if a company doesn’t grow its value, the RSUs will remain valuable.
Because RSUs do not have a strike price, they have better downside protection relative to options. Public companies often grant fewer RSUs than they would options because RSUs are more valuable.
Securities with downside protection have features that protect or enhance their value even when a company is performing more poorly than expected.
When you grant RSUs, you typically do not need to establish their fair market value. This means you do not need to pay for a 409A valuation. Many private companies still want to know their common stock value for other reasons like ASC 718, but it is not a requirement for granting RSUs.
RSU recipients do not become shareholders until they receive stock. Many receive cash instead of stock, so unless they hold stock, they do not have shareholder rights. This may be less valuable to employees but is generally better for the company.
So how do stock options and RSUs compare?
RSUs vs. Stock Options
One of the best ways for private company CFOs to understand RSUs is to compare them to traditional stock options. In the US, there are two kinds of stock options–ISOs and NSOs. For our example, we’ll just use ISOs.
We put together a comparison table to help out. We also highlighted the key differences in yellow.
RSUs vs. Stock Options
|Restricted Stock Units (RSUs)||Incentive Stock Options (ISOs)|
|Grant date||Dated upon issuance which can be anytime||Dated upon issuance which can be anytime|
|Exercise price||RSUs do not have a strike price.||Set to FMV of underlying security--usually common stock (110% of FMV for shareholders with a stake of 10% or more in the company)|
|Vesting||Can be vested based on time, performance, or any other milestone including change-of-control||Can be vested based on time, performance, or any other milestone including change-of-control|
|Shareholder rights||RSUs do not grant the recipient shareholder rights including voting or dividend rights. The recipient of an RSU will gain shareholder rights if the company gives the person stock not cash upon vesting.||ISO recipients become full shareholders upon exercise.|
|409A treatment||Typically do not require a 409A valuation||Typically require a 409A valuation|
|Settlement||RSUs are settled according to terms of agreement. Can often defer settlement for better tax treatment. Deferrals beyond a few months could trigger adverse 409A consequences.||No settlement. After vesting is achieved, ISOs become common stock when the employee chooses to exercise. This provides more flexibility to the employee.|
|Payment type upon settlement / exercise||Cash or stock||Stock|
|Taxation||Taxed on vesting. Possible to get capital gains treatment on subsequent gains if the company grants stock on settlement and the employee holds the stock for 12+ months.||If a qualifying disposition is made, taxes are paid at time of sale at the long-term capital gains rate. If a non-qualifying disposition is made, taxes are paid at time of sale at the ordinary income tax rate.|
An RSU (with equivalent vesting) will be more valuable than an option. This is because RSUs have more downside protection. This means you are giving more to your employees. Giving more may be good or bad depending on your goals.
If the terms of an RSU specify that it does not vest until sale of the company, the recipients of RSUs will not become shareholders and therefore will not have shareholder rights. This vesting trigger is common with RSUs.
Having fewer shareholders is generally good for a company.
The one area where options are superior is taxation. It is possible for the recipient of an ISO to pay taxes on 100% of their gain at the lower long-term capital gains rate.
But as previously discussed, many, if not most, employees do not exercise their ISOs early enough to receive long-term capital gains. Therefore they pay taxes at the higher ordinary income tax rate anyway. Also, though RSUs are taxed at vesting at ordinary income rates, any subsequent gains could be taxed as long-term capital gains.
So the advantages of options may not be as big as you might think. And there are certainly some real advantages to RSUs.
Who Uses RSUs?
Public companies use RSUs frequently. They often combine RSU grants with other forms of compensation including options.
Pre-IPO private companies also use RSUs frequently. Facebook pioneered the usage of RSUs. It did this to avoid having to register as a public company too early. It may have also issued RSUs to give some downside protection to employees if the company’s valuation was overstated.
Other private companies use them much less frequently. With the passage of 409A legislation several years ago, many experts predicted RSUs would overtake options. This has not happened. Only about 2% of the 10,000+ companies on our system use RSUs. However, usage of RSUs is increasing rapidly in this segment as well.
How Blueleaf Structured RSUs to Make Them Better Than ISOs
So let’s go back to our original point. Is it possible to make RSUs better than ISOs? RSUs have traditionally had a few major problems relative to ISOs.
You typically have to make cash or stock payments to employees as the RSUs vest. Since a lot of private companies are cash poor, making cash payments is hard. If you make a stock payment, then you create the shareholder problems we mentioned above.
Also, your employees will have to pay taxes on the RSUs as they vest. This could be burdensome.
Lastly, your employees can only get long-term capital gains if they convert their RSUs to stock and hold the stock for 12+ months. So this is not an advantage over options.
However, Blueleaf and their attorneys at Goodwin Proctor found a way to minimize these problems.
Blueleaf structured their RSUs to be subject to both a time-based condition and a performance-based condition. The time-based condition is similar to any other vesting plan. The performance-based condition is defined as the sale of the company.
They additionally structured their RSUs so that when an employee leaves the company, they retain the portion of the RSUs that met the time-based vesting requirement. Employees will continue to hold these RSUs until the time when they fully vest (sale of the company). This prevents employees from feeling trapped – they can leave the company without losing the RSUs they’ve worked for.
Lastly, there is a provision that allows Blueleaf to accelerate vesting at any time so that company management can give actual stock to RSU holders whenever they want.
That’s it! With the exception of some potential tax benefits, Blueleaf successfully created an RSU that is better in just about every way than an ISO.
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