employee equity compensation in tech startups
Restricted stock units (RSUs) are given to employees as a form of compensation by mature startups. With an RSU, your employer promises to give you a company share at a later time (as determined by the vesting schedule).
Successful late stage companies with high valuations offer RSUs as a recruiting and retention tool. At this stage, offering stock options can be less compelling to potential new hires because the strike price is high. RSUs allow employees to receive shares for no cash out of pocket.
Shares issued from RSUs are given to you according to a vesting scheme. In most cases, the vesting scheme will have both a time trigger and an exit trigger. This is called double trigger vesting.
Double trigger vesting means that shares vest according to schedule while you’re working at the company, except they won’t be issued to you until there is an exit. This is put in place to protect employees from being hit with a high tax bill on shares they can’t yet sell.
In case there’s only a time requirement to the vesting scheme, the shares are issued to you as you vest. The most common schedule is spread over four years with a one year cliff.
With stock options, you are given the right (option) to purchase (exercise) the shares at a specified price (strike price). You may exercise those rights as the options vest or at a later date of your choosing.
With stock options, early stage employees can realize tax benefits by exercising when the difference between the strike price and the fair market value is narrow. This means that the value reported as ordinary income is lower, and then, after holding the shares for a year, any additional increases in fair market value would be reported at the capital gains rate which reduces your tax bill.
With RSUs, you don’t have a choice of when you get the shares. They’re given to you according to the vesting scheme and you are taxed at the market value of those shares. From a tax perspective, it’s as if the company had just given you the cash – it’s reported in your paystub and W2 and taxed as ordinary income. As a late stage employee, the market value of company shares is probably high, so this could mean a large tax bill.
If your RSUs vest according to a double trigger scheme then the shares are issued to you only when you’ll have the option to realize the cash value of your shares, which will allow you to pay the taxes. This means that you’ll be able to sell some of your shares to pay the taxes due on the issuance.
If however the RSUs are issued according to a vesting scheme with only the timing component, then you should inquire about whether the shares are eligible for the 83(i) election. If this is possible it would allow you to defer paying taxes by five years. However, you’ll need to make the election within 30 days of the shares being delivered to you.
If neither of the above applies, then you’ll need to prepare to pay taxes on those shares out of pocket.
If your company has double trigger vesting, check to see if you vest on the date of your IPO or after the lock up period. If your company doesn’t do a direct listing, your lock up period will most likely be 90 or 180 days. This simply means you won’t be able to sell shares until the lock up date expires.
If the second vesting is triggered on the date of the IPO then you’ll need to be prepared to pay the tax burden out of pocket. However, you’ll be able to get the cash in 90 or 180 days when the lockup expires and you’re able to sell your shares.
If the RSUs aren’t subject to double trigger vesting and aren’t eligible for the 83(i) election, you will need to start saving according to your vesting schedule to ensure that you can keep up with the taxes. Consider what bracket that income will be taxed in and start allocating savings through the vesting dates.
Investing in private companies is risky and it’s especially difficult to estimate how much your shares will be worth in the future. One thing we can say with certainty is that whatever the fair market price of those shares is now, it’s likely it won’t be the same in the future. As with the case of exercising stock options, you’ll definitely want to consider the company’s exit strategy and whether you want to make this investment in the company.