Three Types of Equity Grants: Options, Restricted Stock, and Restricted Stock Units
Startup founders strive to attract and retain talented employees. It’s easy for small businesses and small law firms to burn through funding by only offering monetary compensation. That’s why it may be a good idea to consider equity grants. This way, you not only preserve your cash and extend your runway, but you can also ensure the incentives are aligned and the whole team is collectively working for an “upside”, which is extremely motivating and effective. This article will help you understand the difference among the three most typical equity grants: stock options, restricted stock awards (“RSAs”), and restricted stock units (“RSUs’’).
Stock options (also known as “employee stock options” or “ESOs”) are a form of equity compensation where a company grants an employee the option to purchase shares of the company at a fixed price (the “strike price”) for a certain amount of time. As a result, the employee is incentivized to work to increase the value of the stock so that they may eventually sell the stock at a higher price (the “market price) for a profit. This form of compensation is also advantageous to companies because equity in the business is not simply given away. The option grants the employee the opportunity to purchase company stock (albeit at a discounted price). Below is a basic example of a stock option grant:
Company A grants an employee the option to purchase 1,000 shares of Company stock on May 31st at $40 per share (the “strike price”). The employee pays $40,000 to exercise the stock option. However, on May 31st, Company A’s stock is worth $100 per share (the “market price”). As a result, the employee’s shares will be worth $100,000, and if the employee sells his or her shares immediately, the transaction will result in a profit of $60,000.
Stock options are often subject to a vesting schedule. This means that an employee may not exercise all of his or her options at once. Rather, the options are granted to the employee bit-by-bit over time. To continue the above example:
The employee’s stock options are subject to a vesting schedule of 25% over four years. After the first year, the employee may purchase 25% of those shares (here, 250 shares) at the strike price. After four years, the employee’s options are “fully vested,” and the employee may exercise the options on all 1,000 shares.
The taxation for stock options is based on the income of selling stocks. Exercising the option to obtain the stock does not produce any immediate income as long as you hold the stock in the year you acquire it.
Stock options are suitable for high-growth startups. The major benefit for the employer is to save precious cash at the early stage. Employees could enjoy equivalent or greater cash benefits when the stock becomes more valuable. However, there are disadvantages to stock options:
1) Employees need to pay money to exercise their options.
2) The stock only becomes valuable after the company creates a public market for the stock or company acquisition. If the company fails to go public or get acquired, or if the company does not perform well and its stock price decreases, the options could become a loss or become worthless.
Another common form of equity compensation is “restricted stock.” As opposed to stock options that grant an employee the option to purchase stock at a certain price, restricted stock is owned outright by the employee once it is issued. The employee does not need to purchase the stock.
Similarly to stock options, restricted stocks are typically subject to a vesting schedule. This incentivizes the employee to remain at the company.
Restricted stock typically takes one of two forms: Restricted Stock Awards (RSAs) and Restricted Stock Units (RSUs). We will discuss the difference between the two below.
Restricted Stock Awards (RSAs):
When an employee is granted RSAs, the employee receives the entirety of his or her shares on the day they are granted. However, the employee’s rights in the stock are restricted until the shares vest (or lapse in restrictions). In practice, these “restrictions” often include the right of the company to repurchase the stock from the employee for little to no cost. Similarly to stock options, the vesting periods for RSAs can be based on a stated period of time, or a goal or achievement of the company. The vesting plan helps avoid the situation where an employee joins the company, receives the RSAs, and then leaves the company immediately.
After the RSAs vest, the employee receives the shares of company stock without further restrictions. The value of RSAs depends on the stock value at vesting. Recipients of RSAs might want to file a section 83(b) election to the IRS, which allows the tax calculation based on the fair market value of the property when it is granted rather than its fair market value on the date that it vests.
Restricted Stock Units (RSUs):
RSUs are a promise to give employees stocks in the future. Unlike RSAs, RSUs are not issued until vested. You could design a vesting plan and distribution schedule for issuing RSUs. The RSUs will have no tangible value until vesting is complete. Any shares that are not time-vested are forfeited at the termination of employment. Because RSAs are issued on the grant date and RSUs are not issued until vested, the tax for RSUs is delayed and calculated on the vested value. In other words, RSUs are not eligible for 83(b) elections. The unvested RSU shares are forfeited instantly upon termination, while unvested RSAs shares are subjected to repurchase upon termination. This equity grant incentive is mostly common with mature companies or later-stage startups.
We would like to show you the differences among the three options in the chart below:
After you understand the differences between the three equity incentives, you also need to keep in mind these equities only hold a monetary value if the company is purchased or the company goes public. During these times the stock trades at a calculated value. The value is often calculated by the number of shares available and the valuation of the company. No matter what equity incentive you choose, there is no better way to share your profits via appreciation and encourage retention to your employees.
Are you an employee trying to understand your equity compensation? Are you a startup looking for the best equity incentive plan for new hires? Let us put you in touch with an attorney who can help explain options and restricted stock: https://www.sleegal.com