Why Stock Options May Not Be the Best Way To Grant Company Ownership to Employees
Discover why stock options may not be the ideal way to grant company ownership to employees and why restricted stock units (RSU) are.
Employers and employees alike agree that having ownership in their company — having a “founder mindset” — is one of the most powerful ways to increase engagement, loyalty, and productivity. More than half of respondents under 35 in a 2019 survey said that ownership through stock options and other forms of equity compensation is important when considering a job change.
Traditionally, for startups, “ownership” meant stock options in which employees are given the opportunity (not the obligation) to buy the company’s stock, which can increase in market value as the company grows. What could be better than owning a piece of a company through employee stock options, especially given you’ve put such hard work into the business?
However, the changing business landscape means those employee stock options may not be the best deal for workers anymore. More and more companies who offer equity compensation through stock options are starting to consider it from their employee's point of view and offer alternatives instead, such as restricted stock units (RSUs).
Before we dive into why stock options may not be best for your company, let’s first discuss…
What are Stock Options?
A stock option is a contract that gives the holder the right, but not the obligation, to buy or sell shares of a stock at a specified strike price based on vesting schedules or performance targets.
When you exercise your options according to the vesting schedule and at a pre-set price, the shares are bought or sold at the strike price. If the price of the underlying stock rises above the strike price, the stock option holder will make a profit and incur tax for the capital gain. If the price has fallen below the strike price, the stock option holder will incur a loss.
Types of Employee Stock Option (ESO)
There are different kinds of stock options: statutory or incentive stock options (ISO) and non-statutory stock options or non-qualified stock options (NQSO). They differ in several aspects, especially in their tax liability.
Incentive stock options are only offered to employees and give the holder the right to purchase stock at a specified price, known as the strike price. Non-qualified stock options can be offered to anyone, including employees, contractors, and consultants. The holder has the right to purchase shares of the underlying stock at the current market price or at a discount.
ISOs may be subject to special tax treatment (the US Internal Revenue Service treats gains on ISOs as long-term capital gains), while NQSOs are not (any gain is considered short-term capital gain).
What are Restricted Stock Units?
An RSU as equity compensation is a grant of company stock or cash valued at the current market price of the stock, which vests over time. Vesting means that the recipient has a right to receive the shares or cash gradually over a period of time, usually four years.
RSUs are not taxable until they vest, which is typically when the employee has the right to sell them. At that point, the employee will pay ordinary income tax on the market value of the shares at the time they vest. If the stock price has increased since the grant was made, then the employee will pay capital gains tax on any increase in value.
Restricted stock units are typically awarded to employees as an incentive to remain with the company for a set period of time.
Single Trigger and Double Trigger RSUs
The units may be subject to a "single-trigger" or a "double-trigger" acceleration.
If the restricted stock unit is subject to a single-trigger vesting, the employee will receive the shares of stock immediately upon the agreed upon trigger. It is typically a requisite service period or performance target specified on the RSU agreement.
If the unit is subject to a double-trigger acceleration, the employee will only receive the shares of stock if two vesting requirements are met: a performance or time-based goal and a company liquidity event.
Reasons Why Companies are Shifting from Stock Options to Restricted Stock Units
Stock options have been the subject of several heated debates as more companies are moving on from them and turning their attention toward restricted stock units. Even tech behemoths such as Google are using RSUs instead of stock options as employee equity compensation. Here’s why:
1. The Risk May Be Too Great (purchase requirement for shares at the strike price)
Are stock options good for employees? A worker granted stock options has to purchase shares instead of being granted equity, as with RSUs. This presents a huge issue as some may not have liquid assets that can allow them to purchase shares using their own money at the strike price.
For example, if an employee enters a company and its stock is worth $20 per share, they can buy stock options for that price. If the company is later sold at $40 a share, they’ll only get the difference between the prices and they have to come up with the purchase price based on the strike price per share.
Alternatively, a restricted stock unit is a promise from a company to give employees and other workers like contractors and advisers, a share of stock. The worker pays nothing upfront. And as long as it has a value above zero, an RSU won’t become worthless.
2. They May Have Tax Concerns (despite alternative minimum tax for ISOs)
With inflation soaring and the cost of living rising, employees are keeping a closer eye on their tax bill, so they might be concerned about getting hit with a big tax bill prior to the company being sold. Not to mention extra piles of paperwork come tax time. When employees exercise stock options, they’re taxed as regular income, as are RSUs.
Taxation of RSUs
RSUs, however, are connected to certain events, such as a new funding round, which helps employees with tax planning. RSUs don’t become taxable until they’re vested, which is simpler for employees, and often means the company has proven its worth when they are received.
3. The Balance Has Shifted
“Investors and founders have changed the model to their advantage, but no one has changed the model for employees,” wrote Steve Blank, professor at Stanford University and founder of multiple companies.
With multimillion-dollar seed rounds, founders risk less than they once did and can often find ways to cash out early. Further, founders often grant themselves restricted stocks instead of common stock options, which essentially allows them to buy the stock at zero cost.
And while venture capitalists often use pro-rata rights to keep their percentage of ownership intact, employees don’t have that posibility. RSUs give employees a fairer deal since they are linked to liquidity events that demonstrate success. Employees have confidence that they will share in that success equally.
4. The landscape has changed
Although the entrepreneurial spirit is strong as ever, companies are staying private longer. The number of publicly listed companies dropped by 52% between the late 1990s to 2016. In some cases, increasing regulation and risk have made the rush to go public less attractive.
Now, companies may not go public in time for the employee to cash in their options. Research shows that the median tenure for an employee between ages 25 and 34 is just under three years. Employees want to feel ownership in the organization, but they don’t want to feel tethered waiting for an IPO or sale that’s far off on the horizon.
What is great about RSUs, especially double trigger restricted stock units, is that they continue to vest even when a worker has left the company. The worker will be awarded the company shares when the liquidity event is reached (given the other applicable vesting requirements have been met).
Offering ownership is still one of the best ways to engage employees and give them a “founder mindset.” But these days, that means looking at it from their point of view and considering the best options for them.
Advantages of Double-Trigger Restricted Stock Units
As opposed to stock options and other forms of employee benefits, double trigger restricted stock units offer a number of advantages for both employees and employers.
For employees, these benefits include greater financial security, enhanced ability to participate in company growth, and more flexibility when it comes to cashing out.
For employers, double trigger RSUs provide a more attractive option for attracting and retaining top talent, fostering a sense of ownership within the organization, and reducing administrative costs related to managing stock.
Greater Financial Security (Value Based on Current Market Price)
One of the main advantages of double trigger RSUs for employees is the greater level of financial security that they provide. These benefits are tied directly to company stock.
This helps to mitigate some of the risks associated with other types of employee compensation, such as stock options, which may not always deliver value in line with the underlying share price.
Enhanced Ability to Participate in Company Growth
Another advantage of double trigger RSUs for employees is the enhanced ability to participate in company growth over time. Whether an individual joins a company when it's just starting out and its stock price is relatively low or joins later as the company becomes more established, double trigger RSUs provide opportunities for individuals to share in their employer's success over time.
This can help employees to feel more invested in the success of their organization and motivated to work toward further growth.
In addition to providing greater financial security and the ability to participate in company growth, double trigger RSUs offer employees additional flexibility when it comes to cashing out upon leaving a company.
Unlike other forms of employee compensation, such as stock options or performance-based bonuses, employees with RSUs can cash out their vested benefits at any time after the RSUs fully vest, without needing to be actively employed by the company.
This flexibility can give employees greater control over their financial future or personal finance and make it easier for them to transition out of a job when they need to without needing to worry about losing access to their stock benefits.
Great for Recruiting and Retaining Top Talent
In addition to providing benefits for employees, double trigger RSUs are also an attractive option for employers, most especially private companies. They can help companies with limited cash flow to attract and retain top talent by offering a form of compensation that in-demand employees find appealing.
Fosters a Sense of Ownership
Double trigger RSUs can help to foster a sense of ownership among employees. Because these benefits are directly tied to company stock, they provide employees with a direct stake in the success of their organization over time.
This is beneficial for tech startups and other private companies as the equity deployment leads to a boost in productivity with the employees more motivated to work toward ensuring the success of the company.
Reduced Administrative Costs for Managing Stock
Finally, double trigger RSUs also offer benefits for employers in terms of administrative costs. Because these benefits are directly tied to the company stock, they do not require additional administration or oversight by the employer, unlike other forms of employee compensation, especially stock options. This makes it easier for companies to manage employee compensation over time.
Overall, double trigger RSUs offer a number of key benefits for both employees and employers. Whether you're looking to attract and retain top talent or simply looking for an efficient way to manage your company's stock equity, these benefits make double trigger RSUs a valuable option for many organizations, particularly private companies.
Choose Upstock to Deploy Employee Equity
If you are looking for a trusted partner to help you set up and manage your employee equity plans, look no further than Upstock. We simplify the process of granting, tracking, and managing equity programs to help you focus on what's important - achieving your business goals.
With Upstock, you can deploy RSUs that offer a range of key benefits for employees and employers alike, including enhanced financial security and flexibility, reduced administrative costs, and more. And, you can achieve all that in just a couple of minutes!
Book a FREE demo today to learn more about how we can help you manage your employee equity programs and optimize the success of your organization.
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