editione2.1.1
Updated September 12, 2022In this section weβll lay out how equity is granted in practice, including the differences, benefits, and drawbacks of common types of equity compensation, including restricted stock awards, stock options, and restricted stock units (RSUs). Weβll go over a few less common types as well. While the intent of each kind of equity grant is similar, they differ in many ways, particularly around how they are taxed.
Except in rare cases where it may be negotiable, the type of equity you get is up to the company you work for. In general, larger companies grant RSUs, and startups grant stock options, and occasionally executives and very early employees get restricted stock awards.
At face value, the most direct approach to equity compensation would be for the company to award stock to an employee in exchange for work. In practice, it turns out a company will only want to do this with restrictions on how and when the stock is fully owned.
Even so, this is actually one of the least common ways to get equity. We mention it first because it is the simplest form of equity compensation, useful for comparison as things get more complex.
βDefinitionβ A restricted stock award is when a company grants someone stock as a form of compensation. The stock awarded has additional conditions on it, including a vesting schedule, so is called restricted stock. Restricted stock awards may also be called simply stock awards or stock grants.
βtechnicalβ What restricted means here is actually complex. It refers to the fact that the stock (i) has certain restrictions on it (like transfer restrictions) required for private company stock, and (ii) will be subject to repurchase at cost pursuant to a vesting schedule. The repurchase right lapses over the service-based vesting period, which is what is meant in this case by the stock βvesting.β
βconfusionβ Restricted stock awards are not the same thing as restricted stock units.
Typically, stock awards are limited to executives or very early hires, since once the value of the shares increases, the tax burden of receiving them (without paying the company for their value) can be too great for most people. Usually, instead of restricted stock, an employee will get stock options.
βDefinitionβ Stock options are contracts that allow individuals to buy a specified number of shares in the company they work for at a fixed price. Stock options are the most common way early-stage companies grant equity.
βDefinitionβ A person who has received a stock option grant is not a shareholder until they exercise their option, which means purchasing some or all of their shares at the strike price. Prior to exercising, an option holder does not have voting rights.
βDefinitionβ The strike price (or exercise price) is the fixed price per share at which stock can be purchased, as set in a stock option agreement. The strike price is generally set lower (often much lower) than what people expect will be the future value of the stock, which means selling the stock down the road could be profitable.
βconfusionβ Stock options is a confusing term. In investment, an option is a right (but not an obligation) to buy something at a certain price within a certain time frame. Youβll often see stock options discussed in the context of investment. What investors in financial markets call stock options are indeed options on stock, but they are not compensatory stock options awarded for services. In this Guide, and most likely in any conversation you have with an employer, anyone who says βstock optionsβ will be referring to compensatory stock options.
βconfusionβ Stock options are not the same as stock; they are only the right to buy stock at a certain price and under a set of conditions specified in an employeeβs stock option agreement. Weβll get into these conditions next.
βtechnicalβ Although everyone typically refers to βstock optionsβ in the plural, when you receive a stock option grant, you are receiving an option to purchase a given number of shares. So technically, itβs incorrect to say someone βhas 10,000 stock options.β
Itβs best to understand the financial and tax implications before deciding when to exercise options. In order for the option to be tax-free to receive, the strike price must be the fair market value of the stock on the date the option is granted.
βtechnicalβ Those familiar with stock trading (or those with economics degrees) will tell you about the Black-Scholes model, a general mathematical model for determining the value of options. While theoretically sound, this does not have as much practical application in the context of employee stock options.
βDefinitionβ Vesting is the process of gaining full legal rights to something. In the context of compensation, founders, executives, and employees typically gain rights to their grant of equity incrementally over time, subject to restrictions. People may refer to their shares or stock options vesting, or may say that a person is vesting or has fully vested.
βDefinitionβ In the majority of cases, vesting occurs incrementally over time, according to a vesting schedule. A person vests only while they work for the company. If the person quits or is terminated immediately, they get no equity, and if they stay for years, theyβll get most or all of it.
Awards of stock, stock options, and RSUs are almost always subject to a vesting schedule.
βDefinitionβ Vesting schedules can have a cliff designating a length of time that a person must work before they vest at all.
For example, if your equity award had a one-year cliff and you only worked for the company for 11 months, you would not get anything, since you havenβt vested in any part of your award. Similarly, if the company is sold within a year of your arrival, depending on what your paperwork says, you may receive nothing on the sale of the company.
A very common vesting schedule is vesting over 4 years, with a 1 year cliff. This means you get 0% vesting for the first 12 months, 25% vesting at the 12th month, and 1/48th (2.08%) more vesting each month until the 48th month. If you leave just before a year is up, you get nothing, but if you leave after 3 years, you get 75%.
βDefinitionβ In some cases, vesting may be triggered by specific events outside of the vesting schedule, according to contractual terms called accelerated vesting (or acceleration). Two kinds of accelerated vesting that are commonly negotiated are if the company is sold or undergoes a merger (single trigger) or if itβs sold and the person is fired (double trigger).
βcontroversyβ Cliffs are an important topic. When they work well, cliffs are an effective and reasonably fair system to both employees and companies. But they can be abused and their complexity can lead to misunderstandings:
The intention of a cliff is to make sure new hires are committed to staying with the company for a significant period of time. However, the flip side of vesting with cliffs is that if an employee is leavingβquits or is laid off or firedβjust short of their cliff, they may walk away with no stock ownership at all, sometimes through no fault of their own, as in the event of a family emergency or illness. In situations where companies fire or lay off employees just before a cliff, it can easily lead to hard feelings and even lawsuits (especially if the company is doing well enough that the stock is worth a lot of money).**
βimportantβ As a manager or founder, if an employee is performing poorly or may have to be laid off, itβs both thoughtful and wise to let them know whatβs going on well before their cliff.
βtechnicalβ Founders often have vesting on their stock themselves. As entrepreneur Dan Shapiro explains, this is often for good reason.
βimportantβ As an employee, if youβre leaving or considering leaving a company before your vesting cliff is met, consider waiting. Or, if your value to the company is high enough, you might negotiate to get some of your stock βvested upβ early. Your manager may well agree that is is fair for someone who has added a lot of value to the company to own stock even if they leave earlier than expected, especially for something like a family emergency. These kinds of vesting accelerations are entirely discretionary, however, unless you negotiated for special acceleration in an employment agreement. Such special acceleration rights are typically reserved for executives who negotiate their employment offers heavily.
Acceleration when a company is sold (called change of control terms) is common for founders and not so common for employees. Itβs worth understanding acceleration and triggers in case they show up in your option agreement, but these may not be something you can negotiate unless you are going to be in a key role.
Companies may impose additional restrictions on stock that is vested. For example, your shares are very likely subject to a right of first refusal, which means that you canβt sell the stock without offering it first to the company. And it can happen that companies reserve the right to repurchase vested shares in certain events.
βDefinitionβ The exercise window (or exercise period) is the period during which a person can buy shares at the strike price. Options are only exercisable for a fixed period of time, until they expire, typically seven to ten years as long as the person is working for the company. But this window is not always open.
βdangerβ Expiration after termination. Options can expire after you quit working for the company. Often, the expiration is 90 days after termination of service, making the options effectively worthless if you cannot exercise before that point. As weβll get into later, you need to understand the costs, taxes, and tax liabilities of exercise and to plan ahead. In fact, you can find out when you are granted the options, or better yet, before you sign an offer letter.
βimportantβ Longer exercise windows. Recently (since around 2015) a few companies are finding ways to keep the exercise window open for years after leaving a company, promoting this practice as fairer to employees. Companies with extended exercise windows include Amplitude,* Clef,* Coinbase,* Pinterest,* and Quora.* However, the 90-day exercise window remains the norm.
βcontroversyβ The exercise window debate. Whether to have extended exercise windows has been debated at significant length. Some believe extended exercise windows are the future, arguing that a shorter window makes a companyβs success a punishment to early employees.
Key considerations include:
Everyone agrees that employees holding stock options with an expiring window often have to make a painful choice if they wish to leave: Pay for a substantial tax bill (perhaps five to seven figures) on top of the cost to exercise (possibly looking for secondary liquidity or a loan) or walk away from the options.
Many familiar with this situation have spoken out forcefully against shorter exercise windows, arguing that an employee can help grow the value of a company substantiallyβoften having taken a lower salary in exchange for equityβbut end up with no ownership because theyβre unable or unwilling to stay for the several years typically needed before an IPO or sale.
On the other side, a few companies and investors stand by the existing system, arguing that it is better to incentivize people not to leave a company, or that long windows effectively transfer wealth from employees who commit long-term to those who leave.
Some focused on the legalities also argue that itβs a legal requirement of ISOs to have a 90-day exercise window. While this is technically true, itβs not the whole story. It is possible for companies to extend the exercise window by changing the nature of the options (converting them from ISOs to NSOs) and many companies now choose to do just that.
Another path is to split the difference and give extended windows only to longer-term employees.
Taken together, itβs evident many employees have not been clear on the nuances of this when joining companies, and some have βloginβsuffered because of it. With the risks of short exercise windows for employees becoming more widely known, longer exercise windows are gradually becoming more prevalent. As an employee or a founder, it is fairer and wiser to understand and negotiate these things up front, and avoid unfortunate surprises.
βconfusionβ Options granted to advisors typically vest over a shorter period than employee grants, often one to two years, and may have have different exercise windows. The FAST templates give some typical guidelines about this.
βDefinitionβ Compensatory stock options come in two flavors, incentive stock options (ISOs) and non-qualifying stock options (NQOs, or NQSOs). Confusingly, lawyers and the IRS use several names for these two kinds of stock options, including statutory stock options and non-statutory stock options (or NSOs), respectively.
In this Guide, we refer to ISOs and NSOs.
| Type | Also called |
|---|---|
| Statutory | Incentive stock option, ISO |
| Non-statutory | Non-qualifying stock option, NQO, NQSO, NSO |
Companies generally decide to give ISOs or NSOs depending on the legal advice they get. Itβs rarely up to the employee which they will receive, so itβs best to know about both. There are pros and cons of each from both the recipientβs and the companyβs perspective.
ISOs are common for employees because they have the possibility of being more favorable from a tax point of view than NSOs.
βcautionβ ISOs can only be granted to employees (not independent contractors or directors who are not also employees).
But ISOs have a number of limitations and conditions and can also create difficult tax consequences.
βDefinitionβ Sometimes, to help reduce the tax burden on stock options, a company will make it possible for option holders to early exercise (or forward exercise) their options, which means they can exercise even before they vest. The option holder becomes a stockholder sooner, after which the vesting applies to actual stock rather than options. This will have tax implications.
βcautionβ However, the company has the right to repurchase the unvested shares, at the price paid or at the fair market value of the shares (whichever is lower), if a person quits working for the company. The company will typically repurchase the unvested shares should the person leave the company before the stock theyβve purchased vests.
While stock options are the most common form of equity compensation in smaller private companies, RSUs have become the most common type of equity award for public and large private companies. Facebook pioneered the use of RSUs as a private company to allow it to avoid having to register as a public company earlier.
βDefinitionβ Restricted stock units (RSUs) refer to an agreement by a company to issue an employee shares of stock or the cash value of shares of stock on a future date. Each unit represents one share of stock or the cash value of one share of stock that the employee will receive in the future. (Theyβre called units since they are neither stock nor stock options, but another thing altogether that is contractually linked to the value of stock.)
βDefinitionβ The date on which an employee receives the shares or cash payment for RSUs is known as the settlement date.
βcautionβ RSUs may vest according to a vesting schedule. The settlement date may be the time-based vesting date or a later date based on, for instance, the date of a companyβs IPO.
RSUs are difficult in a startup or early stage company because when the RSUs vest, the value of the shares might be significant, and taxes will be owed on the receipt of the shares.* This is not a bad result when the company has sufficient capital to help the employee make the tax payments, or the company is a public company that has put in place a program for selling shares to pay the taxes. But for cash-strapped private startups, neither of these are possibilities. This is the reason most startups use stock options rather than RSUs or stock awards.
RSUs are often considered less preferable to grantees since they remove control over when you owe tax. Options, if granted with an exercise price equal to the fair market value of the stock, are not taxed until exercise, an event under the control of the optionee. If an employee is awarded an RSU or restricted stock award which vests over time, they will be taxed on the vesting schedule; they have been put on βautopilotβ with respect to the timing of the tax event. If the shares are worth a lot on the date of vesting, the tax burden can be significant.
βconfusionβ You donβt want to confuse restricted stock units with restricted stock, which typically refers to restricted stock awards.
Usually you need the cash to buy sharesβmaybe more than you can afford to pay at exercise time. Another, less common approach to be aware of is for companies to allow the person exercising options to avoid paying the cash up front and instead accept a promise of payment in the future.
βDefinitionβ A company may accept a promissory note to exercise compensatory options. Essentially, a promissory note is like giving an βIOUβ to the company instead of paying the company cash for shares. The note may either be a recourse promissory note or non-recourse promissory note. βNon-recourseβ means the lender (the company) is prohibited from seeking a deficiency payment from the borrower (the recipient of the stock) personally if they do not pay; they only can foreclose on the property itself (in this case the stock).
βtechnicalβ The tax consequences to the company and the optionee depend on how the note is structured. If the note is non-recourse, for state law purposes the company will consider you an owner of the shares received in exchange for the non-recourse note, but the IRS will consider the shares still an option until the promissory note is paid (which would also affect timing for long-term capital gains).
βtechnicalβ Non-recourse promissory notes can also be used to extend option windows on stock options that are expiring (for example, after 10 years), while not requiring the holder of the options to pay until later, when the stock may be liquid or have higher value.
Of course, use of promissory notes is complex and entirely at the discretion of the company. Individuals considering the idea should discuss with a lawyer as well as the company.
While most employee equity compensation takes the form of stock, stock options, or RSUs, a complete tour of equity compensation must mention a few less common forms.
βDefinitionβ Phantom equity is a type of compensation award that references equity, but does not entitle the recipient to actual ownership in a company. These awards come under a variety of different monikers, but the key to understanding them is knowing that they are really just cash bonus plans, where the cash amounts are determined by reference to a companyβs stock. Phantom equity can have significant value, but may be perceived as less valuable by workers because of the contractual nature of the promises. Phantom equity plans can be set up as purely discretionary bonus plans, which is less attractive than owning a piece of something.
Two examples of phantom equity are phantom stock and stock appreciation rights:
βDefinitionβ A phantom stock award is a type of phantom equity that entitles the recipient to a payment equal to the value of a share of the companyβs stock, upon the occurrence of certain events.
βDefinitionβ Stock appreciation rights (SARs) are a type of phantom equity that gives the recipient the right to receive a payment calculated by reference to the appreciation in the equity of the company.
βDefinitionβ Warrants are another kind of option to purchase stock, generally used in investment transactions. For example, in a convertible note offering, investors may also get a warrant, or a law firm may ask for one in exchange for what is in essence vendor financing. They differ from stock options in that they are generally shorter, stand-alone legal documents, not granted pursuant to an equity incentive plan. In contrast, such a βplanβ is intended to be used more broadly for employees, contractors, advisors, and board members.
Employees and advisors may not encounter warrants, but itβs worth knowing they exist.
The awarding of equity compensation can give rise to multiple types of taxes for the recipient, including federal and state income taxes and employment taxes. Skip ahead to understand how taxes on equity work, but if you have time, this section gives a technical summary of tax fundamentals, just in case you (like most people!) never really figured out all the numbers on your pay stub.
Given the complexity, most taxpayers arenβt aware of how their tax is calculated. It does take up thousands of pages* of the federal tax code and involves the intricate diversity of state tax law as well.*
You donβt need to know every detail, and can rely on software and professionals to determine the tax you owe, but we do suggest understanding the different kinds of taxes, how large they can be, and how each is βtriggeredβ by different events.