How restricted stock units work in startups?
Compensation for staff can be difficult for many new businesses. Startups strive to attract excellent employees and their industry’s best talent.
However, they are often strapped for cash and need to keep overhead costs to a minimum.
This makes it difficult for startups to recruit skilled employees and credible names in the early stages.
But, there is a way out of this by providing equity compensation to employees.
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Restricted stock units, commonly known as RSUs, are a common way for startups to balance these interests.
In this article, we will take a deeper look into the pros and cons of RSUs and how they differ from other compensation schemes.
We’ll also look at the benefits that they provide, and what can be expected in return.
Below we’ll cover:
- What are Restricted stock units?
- When can startups offer RSU’s?
- What are the differences between RSUs and stock options?
- Why do startups give restricted stock units?
- Calculating the distribution of RSUs
- Example of how RSU stocks work
- What are some of the benefits of restricted stock units (RSUs)?
- What are the drawbacks of restricted stock units (RSUs)?
- Restricted stock units tax implications
First, let’s take a look at what exactly RSUs are.
1. What are restricted stock units?
RSUs are a type of stock option that gives workers, executives, directors, and other advisors or experts the opportunity to receive shares in a business at a later date.
They are often used as a form of compensation for company key team members and others.
RSUs can include limitations on when and how they may be vested.
The vesting of restricted stock units (RSUs) may be time-based or performance-based.
Time-based vesting of RSUs is tied to specific milestones leading up to the fully vested date.
During this time, the employee is required to continue to offer services.
A time-based vesting period is, for example, restricted stock units that vest after five years of employment with a corporation.
A performance-based vesting term, on the other hand, requires the accomplishment of specific business performance milestones prior to vesting.
The company may also set up a structure in which RSUs are partly based on time and partially based on performance.
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Or, the company may fix the vesting amounts in a number of ways when it comes to time-based vesting.
In a “cliff” vesting plan, all RSUs vest at the same time. However, in a “graded” vesting schedule, RSUs start vesting before the agreed-upon vesting date or benchmark.
A “cliff” schedule means that a company may grant an employee 100 restricted stock units (RSUs) that vest after five years of service.
In that case, all of the 100 shares vest at the end of the five-year period.
The parties may agree to a “graded” vesting plan in which 25 RSUs vest after the third year of employment.
Another 25 RSUs vest after the fourth year of employment, and the last 50 RSUs vest after the fifth year of employment.
Companies may also combine vesting plans so that a part of the stock is subject to cliff vesting.
And the remaining portion vests at different stages over a given time period as mentioned above.
The RSUs are forfeited and the corresponding shares are not issued if the recipient fails to meet the vesting requirements for their RSUs.
Because RSUs represent the right to shares in a company if a specific event occurs in the future, they do not carry voting rights with them.
However, once fully vested, the shares in the company that underpins the RSUs are transferred to the recipient.
And they come with all of the rights that shareholders in the company have, which can also include voting rights.
Understanding how restricted stock units work in startups will give you a better handle on managing them.
2. When can startups offer RSUs?
Before stock or other forms of startup equity compensation can be issued, the company may comply with certain regulatory requirements.
Some may wait until they have completed a 409a valuation.
The process of determining the fair market value of the company’s common stock is known as a 409a valuation.
The market value may differ from the valuation given to the company by investors throughout the fundraising process.
As a result of this, after raising money, the company would need a new official valuation.
And that figure will influence how much stock may be offered to advisers, workers, and others.
If the shares are not issued in accordance with a 409a valuation, there could be legal and tax implications.
Though once a legal entity has been formed, and the stock has been created, then shares can be issued at will.
The RSUs will be expected by investors to be in place. It shows them that you are keeping the team motivated for the long run.
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3. What are the differences between RSUs and stock options?
Employees who have stock options have the right to buy company shares at a certain price and within a specific time period.
A company’s stock may increase in value between the time of the offer and when stock options vest.
Thus, allowing an employee to purchase shares at a cheaper price than the current market price.
Stock Options’ taxes can be a little more tricky than RSUs. RSUs may be less complicated.
For various reasons, an employer offers a certain number of shares to an employee for things such as time in service, job performance, etc.
When these shares vest, the employer then has two options: either release the stock to the employee, who then has the option to sell the stock.
Or pay the employee the cash equivalent of the value of the shares.
RSUs allow the recipient to defer income recognition until they exercise their contractual right to stock, as long as they comply with Section 409A.
Employees at a privately held company may be in a better position to sell their shares to pay their taxes.
RSUs are a contractual right to stock rather than real stock. This is why the recipient only becomes a shareholder when the company settles the right with stock.
Shareholders vote on crucial corporate matters and have legal rights as minority shareholders.
Thus, the number of shareholders may affect a company’s ability to stay private. Remember, shareholder status is important.
4. Why do startups give restricted stock units?
Employers use RSUs as a compensation and retention strategy.
One of the advantages of a startup business offering RSUs is that they are often low on cash.
RSUs may help alleviate this burden by providing workers with shares in exchange for services rendered, thus lowering their overhead costs.
Employees who own stock in the company they work for are also more inclined to perform better.
They’ll work in a manner that helps the company expand and succeed, which in turn will increase the value of their stock.
Also, employees who have unvested RSUs are more likely to remain with the company until the shares vest and the money becomes solely theirs.
Working out an adequate compensation plan for your employees when you’re short of funds is just one hurdle. If you would like more information on the startup hurdles every entrepreneur needs to overcome, check out this video. I describe some in-depth info you’ll find helpful.
5. Calculating the distribution of RSUs
Calculating the right value of an equity compensation plan can be challenging.
The employee’s role, for example, can have a big impact on the potential ownership percentage.
A typical early-stage startup, for example, may issue shares as follows:
- Advisor 2%
- Senior Developer: 1%
- Senior Business Development Employee: 0.35%
6. Example of How RSU Stocks Work
Following the vesting date, the employee receives shares of the RSU stocks.
At this point, the employee will normally have the same rights as a regular common stockholder, including dividends and voting.
The following is an example of how RSUs work:
- Jon works as an employee at “Example Company Inc”
- Example Company Inc. awards 1,000 RSUs with a fair market value of $25 each.
- RSUs have a value of $25,000 at the time of the award.
- The RSUs get vested at an FMV of $30 after three years.
- The RSUs are worth $30,000 at the time of vestment.
RSUs, as you can see, are a great way to motivate key workers to fulfill performance or time targets.
Startup employees can not only become shareholders, but they can also earn extra money depending on their performance.
As a result, departments become more concerned with the overall performance of their teams.
7. What are some of the benefits of restricted stock units (RSUs)?
The advantage of an RSU is that it enables the employee to participate in the company’s growth and success.
After the shares have fully vested, the employee has the option to keep or sell them.
If the employee sells the stock, he or she may either spend the money right away or reinvest it in other assets to diversify their portfolio.
RSUs can provide employees with a feeling of belonging to the business by allowing them to own a portion of it.
Aside from that, RSUs have the following advantages:
- Simplicity. RSUs may be simpler to understand than other kinds of equity compensation, such as stock options. The vesting schedule specifies when the shares will be given, and the formula for determining the value is straightforward.
- There is no need to purchase. Employees who have stock options can buy shares of company stock at a certain price, known as the strike or exercise price. The shares in RSUs only become the recipients after they have vested; no purchase is required. RSUs are often less expensive than stock options for employees since some companies can surrender shares to help pay taxes.
- They retain their value. RSUs will retain their value until the company’s stock price falls to zero, but stock options might not. When the strike price of stock options is lower than the market price, an employee may exercise their options. They can benefit from the difference by buying shares at the lower strike price and then selling them at the higher market price.
- Flexibility: Even if an employee quits the company, once the shares have vested, they are theirs to keep. RSUs provide workers with more options, especially if the business is publicly listed. Employees may sell their vested stock to support other goals, such as contributing to retirement accounts or paying off debt. Or, saving for a down payment on a home, or contributing to a child’s college savings account.
8. What are the drawbacks of restricted stock units (RSUs)?
One downside of owning RSUs as an employee is that the funds are not transferred until the shares have fully vested.
If an employee leaves the company or is fired before the shares are fully vested, then those shares go straight back to the company.
Another downside is that the shares are subject to risk and are dependent on the success or failure of the startup company in question.
If the business does not perform well, the value of the stock may decline.
When shares are not completely vested, they are only an unfilled promise to pay the share price when the shares are fully vested.
The taxation of RSU compensation is another downside.
Because RSUs are taxed as regular income as they vest, the employee has limited tax planning options.
9. Tax Implications
When RSUs are granted, they can have substantial tax implications.
Because the recipient does not receive any property, RSUs are not a taxable event in themselves.
Rather, the property is transferred in the future when the vesting conditions have been met.
When restricted stock units (RSUs) vest and become liquid, they are subject to taxation.
In many circumstances, an employer might look to withhold a portion of the RSUs from salaries as payment for taxes due at the time of vesting.
An employee may also be given the option of paying taxes in cash to keep all of the vested RSUs.
In any case, RSUs will be taxed at regular income rates, which, depending on the level of salary, may be nearly forty percent at the federal level (plus Medicare and Social Security taxes).
There may also be extra taxes depending on the state.
In certain situations, equity-based compensation plans may be the best option for a company.
It enables companies to stabilize cash flow while simultaneously increasing employee loyalty and motivation levels.
We hope that this article has answered any questions that you may have had about RSUs and startups.
And that you now have a better understanding of whether or not you will benefit from utilizing RSUs.
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This article is for informational purpose only. You should consult with your lawyer for proper legal advice.