Employee Equity: Restricted Stock and RSUs
For the past six weeks, we've been talking about employee equity on MBA Mondays. We've covered the basics, some specifics, and we've discussed the main form of employee equity which are stock options. Today we are going to talk about two other ways companies grant stock to employees, restricted stock and restricted stock units (RSUs).
Restricted stock is fairly straight forward. The company issues common stock to the employee and puts some restrictions on the stock. The restrictions typically include a vesting schedule and some limits on how the stock can be sold once it is vested.
The vesting schedule for restricted stock is typically the same vesting schedule as the company would use for stock options. I am a fan of a four year vest with a first year cliff. The sale restrictions usually include a right of first refusal on sale for the company. That means if you get an offer to buy your vested restricted stock, you need to offer it to the company at that price before you can sell it. There are often other terms associated with restricted stock but these are the two big ones.
A big advantage of restricted stock is you own your stock outright and do not have to buy it with a cash outlay. It is also true that you will be eligible for long term capital gains if you hold your restricted stock for at least one year past the vesting period. There currently is a significant tax differential between long term capital gains and ordinary income so this is a big deal.
The one downside to restricted stock is you have to pay income taxes on the stock grant. The stock grant will be valued at fair market value (which is likely to be the 409a valuation we discussed last week) and you will be taxed on it. Most commonly you will be taxed upon vesting at the fair market value of the stock at that time. You can make an 83b election which will accelerate the tax to the time of grant and thus lock in a possibly lower valuation and lower taxes. But you take significant forfeiture risk if you make an 83b election and then don't vest in all of the stock.
If you are a founder and are receiving restricted stock with nominal value (penny a share or something like that), you should do an 83b election because the total tax bill will be nominal and you do not want to take a tax hit upon vesting later on as the company becomes more valuable.
This taxation issue is the reason most companies issue options instead of restricted stock. It is not attractive to most employees to get a big tax bill along with some illiquid stock they cannot sell. The two times restricted stock make sense are at formation (or shortly thereafter) when the value of the granted stock is nominal and when the recipient has sufficient means to pay the taxes and is willing to accept the tradeoff of paying taxes right up front in return for capital gains treatment upon sale.
Recently, some venture backed companies have begun to issue restricted stock units (RSUs) in an attempt to get the best of stock options and restricted stock in a single security. This is a relatively new trend and the jury is still out on RSUs. Currently I am not aware of a single company in our portfolio that issues RSUs but I do know of several that may start issuing them shortly.
A RSU is a promise to issue restricted stock upon the acheivement of a certain vesting schedule. It is a lot like a stock option but you do not have to exercise it. You simply get the stock like a restricted stock grant. And there is an added twist in some RSU plans that allow the recipient of an RSU to delay the receipt of the stock until the stock is liquid. Combined, these two features may remove all of the tax disadvantages of restricted stock because the employee would not have a taxable event until the vesting schedule is over and possibly until the stock becomes liquid. I say "may remove all of the tax disadvantages" because I believe that the IRS has never tested the tax treatment of RSUs. Therefore RSUs are an "adventure in tax land" as one general counsel in our portfolio would say.
I do not believe there is an optimal way to issue employee equity at this time. Each of the three choices; options, restricted stock, and RSUs, has benefits and detriments. I believe that options are the best understood, most tested, and most benign of the choices and thus are the most popular in our portfolio and in startupland right now. But restricted stock and RSUs are gaining ground and we are seeing more of each. I cannot predict how this will all change in the coming years. It is largely up to the IRS and so the best we can hope for is that they don't mess up what is largely a good thing right now.
Employee equity is a critical factor in the success of the venture backed technology startup world. It has created significant wealth for some and has created meaningful additional compensation for many others. It aligns interests between the investors, founders, management, and employee base and it a very positive influence on this part of the economy. We strongly encourage all of our portfolio companies to be generous in their use of employee equity in their compensation plans and I believe that all of them are doing that.
In a subsequent post, can you go through the history of the 4 year vest/1 year cliff tradition? It’s incredibly unfriendly from the employee’s point of view, especially from the perspective of an early employee. I don’t want to threadjack here so I’ll keep my reasons quiet until you post on the topic, though 🙂
i’ll post about it next weekit might be unfriendly to the employee but it is the right thing forthe company to protect it from bad hires
Thanks. My core objection is to the cliff (not the vesting schedule itself) for early (especially/defined as? pre-valuation) employees.
I’m looking forward to this discussion.Please be certain to address vesting acceleration for change of control. For early key hires, this is the protection hardest to get and one that provides the rope to navigate the ‘cliff’ as Dan mentions below.
Sounds like next week’s topic will be vesting
Very true. If the employee is there for the long term, the first year cliff shouldn’t matter to them. Otherwise, you end-up giving stock too early if the employee doesn’t work out. The company is not in the businesss of “distributing stock”. It has to be earned.
I under stand it a bit, but could someone explain how precisely what a four year vest one year cliff means? Does the cliff simply mean that until a year has elapsed the employee’s options don’t start vesting?
It means that you vest in 25% of the award on the first anniversary of the vesting start date (generally the VSD is the hire date or date that award was granted, the VSD is chosen by the board at the time of grant). The other 75% of the award generally vests in 36 monthly installments over the next 36 months.[I feel obligated to point out that even if you’re my client, my blog comments are not legal or tax advice. More information at http://tinyurl.com/blogdisc… ]
Ah, that makes sense, thanks a lot!and for the extranormal video as well!
they may not be legal or tax advice, but they are damn goodthanks!
Fred, very helpful particularly around RSU’s – as your portfolio starts to gain experience with them, it would be great to do a repost on the pros/cons of RSU’s as compared to options and restricted stock.Also, possibly too far afield, but there always seems to be questions about what type of business entity you should be – LLC, C Corp, S Corp, etc. if you plan to offer these types of benefits. I would be interested to see this group’s thoughts on that topic as well.
we did that early on in MBA Mondayshere’s the posthttp://www.avc.com/a_vc/201…
oops – I actually remember that one now. Should have checked first before suggesting. thanks.
Good overview, Fred, and good advice as well. Especially in today’s day and age, with the tax and regulatory so uncertain, it is prudent to use a tool that is time-tested and well-understood (at least, pretty well understood) by recipients as well as Government regulators and tax authorities. I think that perhaps the most important take-away is the importance of being generous in the distribution of employee equity. I’d only add that to the extent possible, e.g., after a larger seed round or Series A, it is important to be flexible in providing trade-offs for new hires between cash and equity. Certain new hires are bigger risk-takers and are willing to give up salary for additional equity. Others less so either due to temperment or life circumstance. In any event, understanding your employees’ utility functions is a valuable component to creating the most attractive and rewarding compensation plans possible.
that’s truehowever, it is also a goal to get all employees into bands of grantsize so that nobody is getting special treatmentthis is tricky stuff
Fred,Are you strictly speaking for startups in this article? Working for a public company, I LOVE receiving RSUs over options for the simple advantage that they can never go under water. I’m speaking from the context of bonuses though, not formation.
YesI’m talking startupsI agree that restricted stock and RSUs are better for public companies
the problem with this in practice is that RSU grants are *much* smaller in value than options grants – on the order of 4-8x. there’s a lot less opportunity for a common employee to make much unless you’re at Goog or Aapl; anywhere else, your RSU grant is usually less worth than your yearly bonus.
yup, that is why RSUs are popular with companies. less dilution.
“It aligns interests between the investors, founders, management, and employee base “Why there is no such alignment when talking about liquidation preference? Why founders & employees do not have a similar treatment for their money&effort? Just want to understand the rationale, nothing else.
i invest $1mm in your company for 20%the company is six months old and this is the first investment of outside capitala week later you sell the company for $2.5mmyou get $2mm for six months worki get a $500k lossdoes that sound fair?no it does notthat is why there is a liquidation preferenceto protect investors from that happening to themi will not invest without oneit is one of the three things i will never invest without
this is an example were we both agree, but let me show the one I´m thinking about:I found a company were I invest in cash $ 0.2 and the team work for 18 months with very low salaries or none.You invest $ 1mm in my company for 20 %After 2 years we sell the company for $ 1mmYou get all your money back.I don´t get any money (+ none of the 18 months low/none salary period)does that sound fair?my point is that liquidation preference is probably quite unbalanced in cases like the above mentioned, which by the way is quite common
why would you sell the company for $1mm in that scenario?you wouldn’t get anything for all of your workyou’d be better off shutting it down
I would sell because ofdrag alone clausesnew start upadmitting the company´s failure
the first one is a problem and a drag should not be enforced in this situationthe second one is a bad answer and you are screwing over the investorin that situation and deserve nothingthe third one is an admission that the sweat equity you put in was abad investment on your part
how does an entrepreneur protect himself from the first problem? are there clauses commonly written into contracts to prevent drag alone clauses in a sale like the one Guillermo described?
you get a good lawyer and you negotiate that provisionit is an entirely reaasonable ask
Albert explains it today http://continuations.com/po…
What all this different ways to do basically the same (give equity to employees) tell me is that tax codes are way too complicated. I know it’s not the subject of this post, but someone should calculate how much work is lost thinking about taxes.
The one downside I see to RSUs as opposed to restricted stock is that you are NOT a shareholder in the company until the vesting period has expired, sometimes even if a liquidity event has happened as you mentioned.As a dedicated employee in a startup am I not entitled to see the bigger picture of the company’s finances and issues, for example? Or am I missing something with restricted stock where they are not treated as common shareholders in the company?
The other reason I can see RSUs catching on is that it helps the bigger startups (right now, Facebook — which uses them — is Exhibit A) give employees equity without running afoul of the SEC rules that require companies with 500 shareholders to file reports as though they were public. With startups getting larger but holding off on IPOs, it seems like that’s going to be a critical issue soon for some like Twitter, Zynga & LinkedIn.
I like the 83b election it seems reasonable, especially in the very beginning where you could give out restricted stock to the founding team with very low tax implications.I think complexity and administration costs in all of these options vs RSU play a role when the amount of dollars that has to go to development/marketing/sales is the what you want to maximize instead of compliance and other things that are not really value creative.
Any rules of thumb as to the size of option grants you would consider generous?
it all depends on stage of company and the position involvedthere are so many variables to be honest
If a startup sets aside stock for RSUs, do they still have to do the 409A valuation on those or are they exempt until a “liquid” time?
the 409a is generally done to give the board comfort on setting option strike pricesi don’t believe they need to do it to grant RSUsbut there are some tax lawuyers/experts lurking in this threadmaybe they can weigh in here
No 409A valuation is necessary upon the grant of an RSU. The Section 409A rules that apply to RSUs do not relate to pricing, but to when the RSUs are settled.[I feel obligated to point out that, even if you’re my client, my blog comments are not legal or tax advice. More information at http://tinyurl.com/blogdisc… ]
Hey Fred – Great series of posts regarding employee equity; nice going. One quick point: the issuance of shares of restricted stock is not subject to IRC Section 409A. Accordingly, it is a good alternative to the issuance of stock options immediately following the company’s incorporation (when, as you point out, the tax impact is presumably nominal). I briefly discuss this issue in paragraph #10 of my post “Issuing Stock Options: Ten Tips for Entrepreneurs” (see http://bit.ly/cy2zPq). Thanks and regards, Scott (@ScottEdWalker)
What’s preventing someone out there for asking for an IRS ruling on RSUs? It seems to combine the best of all worlds, beyond the issues of how taxes with it working.Also, what are some more common restrictions when it comes to sale?
that is called “opening pandora’s box”
“And there is an added twist in some RSU plans that allow the recipient of an RSU to delay the reciept of the stock until the stock is liquid. Combined, these two features may remove all of the tax disadvantages of restricted stock because the employee would not have a taxable event until the vesting schedule is over and possibly until the stock becomes liquid. I say “may remove all of the tax disadvantages” because I believe that the IRS has never tested the tax treatment of RSUs. Therefore RSUs are an “adventure in tax land” as one general counsel in our portfolio would say.”Just to put a finer point on this comment, the tax rules around plain vanilla RSUs for public companies are quite clear (as least as far as tax rules go). The complication arises in that the use of RSUs with delayed settlement until liquidity in the private company context raises Section 409A issues that make the Section 409A option pricing rules appear logical and straightforward. This is compounded by the fact the IRS has a “no ruling” position with respect to the issuance of private letter rulings around Section 409A issues (see Revenue Procedure 2010-3 Section 3(42)).[I feel obligated to point out that, even if you’re my client, my blog comments are not legal or tax advice. More information at http://tinyurl.com/blogdisc… ]
thank youyou may get asked to do a guest post if you keep this up 🙂
Boy you are doing a good job with all this helpful info Fred.It might be good for your brand (read: great PR), and why not? But it’s helping lots of people as well.Very appreciated.
that’s called a win-win
Fred, what an informative post.Curious if you have ever employed the following. by using a preferred/common structure with limited participation rights, you can often get fair market value of the common down, substantially below the conversion price of the preferred (due to the participation right).In the upside scenarios, the participation right vanishes, and the common recovers quickly. In this situation, it allows boards more air time to grant options before the next valuation event.this doesn’t work well in structures with majority common stock so I have seen situations where the founders stock is given as a preferred class versus the option pool which is common stock.
yes, i’ve seen structures like thisbut i have been trying to simplify cap structures and participation is something i’ve been moving away from for the past decade
thanks charlie. fixed. gotta make my 6th grade english teacher proud
the thing you should never do is fire an employee shortly before the cliff date without giving them some vestingthat is just bad faith