Startup equity compensation can take many forms, but the most common are restricted stock and stock options. This article will help you understand the difference between the two.
Startup Restricted Stock
Restricted stock (sometimes called a restricted stock award or RSA) is a grant of common stock for a startup. It is often granted to founders or employees instead of or in addition to cash salaries. There are two main restrictions on restricted stock:
- Vesting: Those who receive restricted stock typically earn their stock over time.
- Transfer: Recipients cannot sell or transfer their shares except under certain conditions set out in the restricted stock agreement.
Startup Stock Options
A stock option in a startup is a form of equity compensation that enables employees to buy company shares in the future at a fixed price, usually the current fair market value. Unlike restricted stock, which grants ownership of the stock to the recipient, stock options simply grant the right to purchase shares in the future. This compensation is often granted to motivate and reward employees, providing them with the opportunity to profit from any future growth in the company’s value.
Differences Between Restricted Stock and Stock Options
Both restricted stock and stock options are common forms of equity compensation, but they have some key differences. Here are a few:
With restricted stock, employees own actual shares of the company from the outset, albeit subject to vesting restrictions. In contrast, with stock options, employees have the right to purchase shares of the company at a predetermined price (the exercise price) at some point in the future.
The tax treatment of restricted stock and stock options can differ significantly. With restricted stock, employees generally pay taxes on the value of the shares at grant or vesting. On the other hand, with stock options, employees typically do not pay taxes until they exercise their options.
Restricted stock may offer more immediate liquidity than stock options because an employee can sell their shares once they become vested (assuming there is a market for them). In contrast, stock options typically require employees to wait until they have been exercised before they can be sold.
Restricted stock carries less risk than stock options since it represents actual ownership in the company. If the company’s value increases, so does the value of an employee’s restricted shares. In contrast, if a company’s value decreases below a stock option’s exercise price, that option may become worthless, which is known as being “underwater.”
It’s important for companies to carefully consider which form of equity compensation makes sense for their particular circumstances and goals. For example, if a company wants to incentivize long-term retention and ownership among its employees, then restricted stock may be more appropriate. On the other hand, if a company wants to incentivize short-term performance or offer potentially higher rewards without diluting existing shareholders’ ownership percentage in the company too much, then it might consider offering employee stock options instead.
Advantages and Disadvantages of Using Restricted Stock Versus Stock Options as Part of Employee Compensation Packages
Restricted stock and stock options are both options for employee compensation. Here are a few key points to consider:
Advantages of Restricted Stock:
- Ownership: Employees own the shares outright, which can give them a greater sense of ownership and commitment to the company’s success.
- Tax Benefits: Depending on how they are structured, restricted stock awards may be taxed at lower rates than stock options.
- Clarity: Restricted stock is often easier for employees to understand than stock options.
Disadvantages of Restricted Stock:
- Risk: If the company’s share price falls before the restrictions on their shares lapse, employees may face risks.
- Liquidity Issues: It may be difficult for employees to sell their shares before they fully vest, which can limit their ability to access cash when they need it.
- Costly Administration: Administering restricted stock plans can be costly and time-consuming for companies.
Advantages of Stock Options:
- Flexibility: Stock options offer more flexibility than restricted stock in terms of timing and pricing.
- Motivation: The value of options depends on the company’s future performance, which can motivate employees to work hard and contribute to its success.
- Lower Upfront Cost: Employees do not typically have to pay any upfront taxes associated with awarding stock options.
Disadvantages of Stock Options:
- Potential Dilution: Issuing new shares through exercising option grants could dilute existing shareholders’ ownership in the company.
- No Voting Rights: Owning stock options does not give employees voting rights or other benefits associated with ownership.
- Complexity: Understanding how stock options work can be challenging for some employees.
When deciding between using restricted stock versus stock options as part of employee compensation packages, companies should carefully weigh these advantages and disadvantages against their business goals and overall compensation strategy.
How Stage of Growth Affects Equity Compensation Choice
When deciding how to compensate employees in a startup, the company’s stage can determine whether to use restricted stock or stock options. One common strategy is:
- Restricted Stock First. At the start of a company, and for the first 12 months or until an equity round of financing occurs, the fair market value of a startup’s stock is often nominal, typically $0.00001 per share. For early employees, it’s best to issue restricted stock at this price. This gives them real ownership in the company that they are taking a risk on, without incurring a tax burden.
- Then Stock Options. However, restricted stock can cause a significant tax burden for employees once the share price exceeds the nominal value. This usually happens at a 409(a) valuation or when the first equity round of financing is raised. When the price is higher than the nominal value, it may actually be disadvantageous for employees to hold restricted stock, so switching to stock options is better.
Ultimately, there is no one-size-fits-all answer when it comes to deciding between restricted stock and stock options. Companies need to carefully consider their business goals, financial situation and industry context to determine which type of equity compensation is most appropriate for their needs.
How to Determine the Fair Market Value of Restricted Stock and Stock Options
Companies offering equity compensation must determine the fair market value (FMV) of their restricted stock and stock options. The FMV influences the amount employees pay for shares and the taxes they owe when exercising options or selling shares.
Startups commonly use two methods to determine FMV:
- 409(a). A 409(a) appraisal determines the FMV of a company’s common stock. It sets the value of shares for a restricted stock award and the strike price for the option. The 409(a) appraisal must be conducted by an independent third party and updated regularly to reflect current market conditions. If the company’s stock price increases significantly, the 409(a) appraisal must be adjusted to reflect the new valuation.
- Recent Funding Round. Companies can use the most recent funding round to value equity compensation. In this case, the FMV will be the price per share that the investors paid in the recent funding round.
Legal Considerations for Offering Equity Compensation to Employees
Offering equity compensation can be a powerful tool for startups to attract and retain top talent. However, it’s important for companies to understand the legal implications associated with these types of arrangements to avoid potential pitfalls.
Here are some key legal considerations to keep in mind when offering equity compensation:
Companies must comply with federal and state securities laws when offering equity compensation. This includes registering any shares or options being offered with the appropriate regulatory bodies, such as the SEC. Failure to comply can result in significant fines and legal penalties.
There are important tax implications associated with both restricted stock and stock options. Companies must comply with relevant tax laws and regulations to avoid potential liability.
Employment Law Considerations
Equity compensation agreements may implicate various employment law considerations, such as minimum wage requirements, overtime rules and anti-discrimination laws. Companies should work with legal counsel to ensure that their equity compensation plans do not violate any applicable employment laws or regulations.
Companies must have clear policies and procedures in place for administering their equity compensation plans. This includes establishing vesting schedules, setting exercise prices and determining how shares will be allocated among employees.
By keeping these legal considerations in mind, companies can ensure compliance with laws and regulations while providing valuable incentives for their employees. Consulting with legal counsel is essential to ensure that all aspects of the plan are properly structured and executed over time.
If you’re looking for legal counsel to help your startup navigate equity compensation, feel free to reach out to us here.