The first startup stock options came about later than you might think: In 1957, Fairchild Semiconductor investors gave options to the company’s founders to align their incentives with the investors’ own. What was at first a novelty quickly became the standard playbook, and today, most US startups grant stock options as a way to align employees’ incentives and create a feeling of ownership over the business.
But despite its importance, startup equity is still a black box for many founders, employees, and even investors. Last week, we explored how employees should think about their startup equity. This week, we’ll look at how founders and their companies should think about structuring their equity pools to take care of their employees (and, of course, to maximize the company’s long-term value).
First, a note on what this post is not: It is not a guide to sizing equity plans, how much equity each employee should receive, or how to think about dilution. Instead, we’ll work through the following subjects:
- The tradeoffs between stock options and Restricted Stock Units (RSUs)
- Whether and when to allow early exercise
- How long post-employment option exercise windows should last.
Stock Options vs. Restricted Stock Units (RSUs)
The general consensus is that startups should offer employees stock options at early and growth stages and RSUs in the later years, as the companies become truly large. Why? It’ll help first to have a common grounding in the various forms of equity.
What are stock options?
Stock options are a common type of equity compensation for employees of early- and growth-stage startups. An option is just what it sounds like: It gives you the option to “exercise” — that is, to choose to purchase a share of the company’s stock — at a pre-determined price (called the “strike price”). That price is typically fixed when you join the company, and it is usually equal to the startup’s current 409a valuation (the fair-market value as determined by a valuation specialist). There are two different common types of employee stock options — incentive stock options (ISOs) and non-qualified stock options (NSOs) — and they are treated differently for tax purposes. More on that difference in a bit.
What are RSUs?
RSUs are compensation issued by an employer in the form of company shares. They are issued to employees through a vesting-and-distribution schedule. Employees typically gain access to their RSUs as they reach employment duration milestones — that is, they have an interest in the company — but they receive no tangible value until vesting is complete. This is very important, because RSUs are assigned a fair market value (FMV) and are treated as taxable ordinary income when they vest (not when they are sold). How and when RSUs vest is a critical design question, and we’ll talk about it (and the ubiquitous “double trigger”) below.
How to think about options versus RSUs
Companies usually switch from options to double trigger RSUs at later stages in their growth. This happens because options typically become less and less valuable to employees over time.
Why? As companies become more successful, options become less valuable because of:
- Cost. Higher strike prices and less depressed 409a valuations increase exercise and tax costs for employees.
- ROI. Later stage companies often have less upside and less risk, but investor preferences create additional risk to employees share value. As a result, the main benefit of options — allowing employees to capture the upside through relatively early exercise — isn’t as important.
- Tax savings. Later stage options are less likely to be eligible for the Qualified Small Business Stock (QSBS) exemption, and with less upside, lower tax rates are less impactful
As options become less valuable, companies often switch to RSUs — and, typically, to the “double trigger” variety.
Why double trigger RSUs?
Options are not considered income when they are granted — only when the are exercised (in the form of the Alternative Minimum Tax) and then when they are sold (usually in the form of capital gains taxes). RSUs, by contrast, count as ordinary income (salary) when they vest. If RSUs vested over time, the holder could find him- or herself in a bind.
Consider this regrettably common scenario: A startup employee receives standard (single trigger) RSUs monthly during their employment, and the IRS treats those RSUs as income when the employee receives them. As a result, the employee could owe taxes on the value of the RSUs every year, even before they are able to (or want to) sell. And to make matters worse, they don’t know when they may be able to sell or for how much. Even at this later stage, many startups fail, and it is easy to dredge up horror stories where startup employees paid taxes on equity only to end up shares that are worth nothing.
Early exercise and option expiration windows
Simply put, founders should give employees the early exercise option and extend the expiration window as long as possible. (Legally and practically, that’s 10 years). To help understand why, let’s take a look at these concepts.
What is early exercise?
Some companies allow employees to exercise their options only once those options have vested — once the employee has completed a certain period of service to the company. You can think of vesting as unlocking your options over time. For example, if you are granted 10,000 options when you start your job and those options are set to be unlocked on a typical schedule — vesting over four years, with a one-year “cliff” — then you would be allowed to exercise 1/4 of the options on the one-year anniversary of your employment, and the remaining options in equal installments over the last three years of your vesting period.
Other companies allow employees to “early exercise” their options — to exercise even before their options have vested. In this scenario, the employee may convert options to shares before the options have vested, and they’ll then take ownership of the resulting shares of stock on that same vesting schedule (and if they leave the company before vesting is complete, the company will have the right to take them back).
The benefit of this approach is that it enables employees to potentially avoid taxes on all of their shares when exercised, reducing their costs. (Here is an article on option exercise costs.) As a result, it can enable employees to keep significantly more money when they sell their shares, in two ways:
- More of the sale is taxed at lower, long term capital gains tax rates, compared to ordinary income tax rates
- It starts the 5-year clock on QSBS, which could allow employees to avoid taxes on their entire sale of stock!
Tldr: Allowing early exercise can help your employees keep significantly more of their hard earned gains when they sell their startup shares by reducing the taxes that would otherwise go to the government.
Option Exercise Window
After employees leave a startup, they typically have between 90 days and 10 years to exercise their options. It seems obvious that more time is better for employees. (It is, and you should give your employees a 10 year window!) But 91% of option packages have an expiration window of 90 days or less according to Carta. This isn’t usually due to bad intent, but instead simplicity and opaqueness.
Most startups give employees ISOs instead of NSOs due to the better tax treatment ISOs receive. However, ISOs legally have to expire 90 days after an employee leaves the company (which is where the typical 90-day policy comes from). To extend beyond that window, the options have to convert from ISOs to NSOs. That move doesn’t require much additional company overhead, so it’s a no brainer for founders and companies.
In summary, if you want to create a better equity plan for your employees, here are some key things to consider:
Offer a stock option plan when your startup is at an earlier stage and double trigger RSUs at later stages
Enable early exercise for your employees when you offer options. (Whether to do this is unique to each company.)
Enable a 10-year exercise window for your employees and educate them on the tax implications of ISO and NSO exercises
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