Business historians think it was the first company to create an employee equity incentive plan. In May , the Illinois Central Railroad Company offered its employees the ability to buy stock in installments. The Massachusetts Labor Bulletin of 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 We often think that tech companies pioneered broad-based employee equity plans.
But companies were doing it back in the late s.
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? Enter the Restricted Stock Unit RSU. Public tech companies often issue RSUs as an alternative to stock options. Facebook , Google , and Microsoft all use them. When you win [with options], you win the lottery. 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.
Stock Options Vs. RSUs | Finance - Zacks
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. Also, sign up here if you want to use Capshare to help you manage your RSU program. This article provides only a high-level overview on RSUs and Options including some tax information.
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: 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. Restricted stock holders are official company shareholders.
Generally, certain conditions, such as vesting, must occur before the holder of RSUs can receive the promised value.
If an RSU recipient receives stock, they become an official company shareholder. The holder of stock appreciation rights SARs does not own stock and is not a stockholder. 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.
Stock options have become the standard at private companies for two primary reasons: Stock options incent employees to increase the value of the company. 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. This turns her 10, options into 10, shares of common stock.
She can now sell her stock for a monetary gain. But there is a wrinkle. This diagram shows the payout to Mary at different values of common stock. 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. 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 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. You should seek the guidance of a qualified tax professional whenever exercising options.
What will her tax be?
Because Mary exercised her shares more than 12 months ago, she qualifies for the long-term capital gains rate. This is a great benefit of ISOs — they can help employees reduce their tax obligation. 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.
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.
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. After all, the point is to incent them to help the company grow.
Stock Based Compensation - Founders Workbench
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. 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 A valuation.
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. 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. 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 A valuation. Many private companies still want to know their common stock value for other reasons like ASC , 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. 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. We put together a comparison table to help out. We also highlighted the key differences in yellow.
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. 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. 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. 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. Other private companies use them much less frequently. With the passage of A legislation several years ago, many experts predicted RSUs would overtake options.
This has not happened. However, usage of RSUs is increasing rapidly in this segment as well. 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. So this is not an advantage over options.Restricted Stock & RSUs: Key Aspects to Know
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. 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.
With the exception of some potential tax benefits, Blueleaf successfully created an RSU that is better in just about every way than an ISO. Ready to start issuing RSUs for your company? Sign up at Capshare. How does the Blueleaf example solve all the problems mentioned? So If that is the case I see how that solves some problems. So if a private company bought Blueleaf employees still could be hit with a tax bill they may not be able to afford. Is that a correct read of this example? Hey Gary, I have the same understanding you do — that the Blueleaf RSU solves some problems but not the short-term capital gains problem.
I believe the author was suggesting that the short-term capital gains problem often occurs with stock options as well. And if the RSU vests on sale then it seems like the employee could afford the tax bill since their stock would be liquid turned into cash. The tax issue with RSUs is understated here. That is the one reason RSUs are not in favor with startups.
Can you explain how the tax issue is understated here compared to ISOs? Basically, RSUs are taxed at vesting. So it the value goes up the employee ends up paying taxes on the value of the underlying stock at the time of vesting. That can be a huge liability, specially for startup companies where the value may increase significantly but the stock is still illiquid. Such that, you have to pay taxes on the higher value at that time while not having cash to pay for the taxes.
Resources Equity Guide for Founders DIY A Tool How to Choose an Equity Solution About Contact Us More Capshare Home Capshare Pricing Request a Demo. Why RSUs Restricted Stock Units Could be Better Than Stock Options At Your Private Company by Jeron Paul Jul 9, Equity Compensation , Issuing Shares , Restricted Stock Units , Stock Options.
Bill Gates prefered stock and RSUs at Microsoft: A Primer on Equity Compensation Disclaimer: 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. Tax Advantages of Options Most private companies granting options to employees use ISOs Incentive Stock Options.
A Conceptual Guide to Employee Ownership for Very Small Businesses
Problems with Stock Options Stock options have worked great for private companies for years. So how do stock options and RSUs compare? Stock Options One of the best ways for private company CFOs to understand RSUs is to compare them to traditional stock options.
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. Can often defer settlement for better tax treatment. Deferrals beyond a few months could trigger adverse A consequences. After vesting is achieved, ISOs become common stock when the employee chooses to exercise. This provides more flexibility to the employee.
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. Manage All Your Equity in 1 Place Manage your cap table, issue shares, analyze funding rounds, and automate all your equity without getting bogged down in spreadsheets and paperwork. Recent Posts A Process: Best Practices and What to Expect Startup Ideas: Can be vested based on time, performance, or any other milestone including change-of-control.
RSUs do not grant the recipient shareholder rights including voting or dividend rights. RSUs are settled according to terms of agreement.