Startups frequently want to grant equity incentives to new hires and advisors. When they do, they want to know: What is the best equity incentive to use?
There Are a Variety of Possibilities
There are a number of different types of awards:
- Stock awards (the issuance of stock, typically subject to vesting)
- Stock options (the issuance of the right to buy a fixed number of shares, at the fair market value of the shares at the time of grant, exercisable after vesting and while providing service or some period of time thereafter; typically not exercisable until vested)
- Restricted stock units (RSUs) (a contract right to receive a number of shares of stock upon vesting)
- Phantom stock or shadow stock plans (a contract right to receive a cash payment based on the increase in the value of the company’s equity during a service period)
Frequently entrepreneurs are coming out of big companies that had RSU programs in place. They think RSUs might be a good choice for a startup.
But RSUs are not a great fit for startups for tax and liquidity reasons.
The Tax & Liquidity Problems
If you receive an RSU you are not taxed on grant. That is good. But you will be taxed on the value of shares delivered on vesting. And you will be taxed on the value of the shares at that time. This is problematic because (1) the timing of the timing of the tax is outside of the control of the award holder (i.e., time goes by), and (2) the shares are typically illiquid and cannot be sold to fund the taxes. Startups usually don’t have cash on hand to help company employees pay their taxes on their equity awards.
(Public companies are different because they have public trading of their shares and sometimes also have cash to help employees pay the taxes. Sometimes public companies will allow the players to pay their income and employment tax withholding by receiving fewer shares on vesting of the RSU. These options aren’t available for startups.)
At least with an option an optionee gets to choose when to exercise. This allows optionees to wait to exercise until they can afford to pay the taxes incident to exercising.
Sometimes companies will defer the vesting of an RSU until after an IPO or until the company is acquired. This is one approach to solve the tax and liquidity problems–but what if someone would have otherwise vested on a 4 year vesting schedule, wants to leave, and the company has still not gone public or been acquired?
Restricted Stock a Better Choice
If you are granting equity awards and your recipient can afford to pay tax on the value of the shares today, then grant restricted stock awards. This is a better choice than an RSU. With an RSU you are signing up to pay tax at a predetermined time (on vesting) but at a value to be determined at that future time. This is a bad idea. You might be signing up to put yourself in a tax find you can afford to get put of.
Think Option or Restricted Stock, Not RSUs
If you are a startup, RSUs are not a great choice. Think either restricted stock awards or stock options.
(By the way, Fred Wilson has written a really good post on these issues as well, which you can find here. As Fred points out, there are more tax complexities and nuances to the RSU tax picture than I’ve described here. Also, if your company is not a startup, but a company ramping to an IPO, an RSU plan might be a good idea. But if you are a startup or early stage, RSUs are more brain damage than they are worth.)