As a startup founder, you rack your brain all day trying to attract and retain talented employees. Instead of burning through your funding by providing solely monetary compensation, it’s always a good idea to consider equity grants. This way you not only preserve your runway, you can also ensure that 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 ways of equity grants: stock options, restricted stock awards (“RSAs”), and restricted stock units (“RSUs”).
Stock options are a type of equity compensation granted by companies to their employees.
They differ from granting shares directly. The employees need to pay money to become shareholders. Giving your employees stock options is giving them the right, not the obligation, to buy certain amounts of stocks in a finite time at a fixed price. The fixed price is also called a “strike price.” If the value of the stock increases over time, employees could make money from the difference between the strike price and the sale price of the stock. The final sale price is also referred to as the “market price.”
Employee X has stock options to buy 1,000 shares on May 31 at a price of $40 per share. The $40 is the strike price, which means the employee needs to pay $40,000 to exercise the options. But when the stock price increases to $100 per share on May 31. The stocks will be worth $100,000. If the employee sells his stocks immediately, the employee’s resulting income would be $60,000.
The taxation for stock options is based on the income of selling stocks. Exercise of 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, the main disadvantage is that: 1) the employees need to pay money to exercise their options, and 2) the stock only becomes valuable after the company creates a public market for the stock or a 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.
Two typical alternatives to stock options are Restricted Stock Awards (“RSAs”) and Restricted Stock Units (“RSUs”). For stock options, employees don’t own the stock until they exercise the options. For restricted stocks, employees would not need additional payment to get the shares. However, they still need to earn the shares with certain requirements.
Restricted Stock Awards (RSAs):
RSAs are given to employees on the day they are granted.
However, the employee’s rights in the stock are restricted until the shares vest (or lapse in restrictions). The restricted period is referred to as a vesting period. 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. Receivers 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):
Unlike RSAs, the RSUs are a promise to give an employee stock in the future. 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) election. The unvested RSU shares are forfeited instantly upon termination, while unvested RSA 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 from 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. Please follow Sleegal AI to gain more knowledge about starting your business.