Transitioning from granting stock options to restricted stock units (RSUs) can offer numerous benefits for a private company – reducing complexity, minimizing equity dilution, and offering lowering downside risk for employees, to name a few. It is a practice that is becoming increasingly popular among late-stage private companies that are close to a liquidity event. The transition can have rippling effects on your shareholder base and overall equity compensation plans, which is why private company CEOs and CFOs should take the time to carefully consider all the implications of granting RSUs versus options.
To help clarify the why, when, and how of transitioning to RSUs, The Circle Community invited three experts to share their experiences on the topic of equity compensation: Linda Amuso, President of Radford; Tracy Knox, CFO of Rover; and David Oppenheimer, advisor, investor and former CFO of Udemy.
(If you’re totally new to this subject or equity grants in general, our article “Equity Compensation: When Startups Should Grant Restricted Stock, ISOs, NSOs, or RSUs” is a great place to start.)
Rationale for Transitioning from Options to RSUs
Stock options have long been a powerful tool for attracting and retaining employees at private companies. However, in the last ten or fifteen years, the landscape of equity compensation has changed in a few significant ways:
- Companies are staying private longer, prolonging the path to liquidity for their shareholders. In the meantime, soaring valuations coupled with increased employee populations are diluting shareholders at a rate of roughly 4-5 percent annually.
- Economic downturns like the dot-com bubble, the 2009 financial crisis, and the most recent COVID-19 crisis have increased the risk of “underwater options,” which can negatively impact the retentive value of a private company’s equity compensation plan.
- The dynamics and culture of equity compensation have fundamentally changed. Private company employees now have higher expectations around the value and liquidity of their equity, which has led companies to adopt more competitive equity strategies.
Combined, all of this has challenged the traditional model of granting options with four or five-year vesting cliffs. Instead, as one of our experts pointed out, companies are moving towards more frequent equity grants with a more diverse range of equity options to keep employees aligned and offer greater flexibility for the company’s equity strategy.
The Benefits and Considerations of RSUs
RSUs have a few unique benefits that make them an appealing grant structure for a late stage private company.
- RSUs are generally easier to value than options in that the value when issued is equal to the common stock valuation and typically vest only when certain conditions are met. Unlike options, RSUs do not need to be exercised: they are converted to common shares and taxed at the time of vesting.
- RSUs tend to be a more attractive equity incentive for late-stage hires leading up to an IPO. This is because options tend to lose some of their upside potential as a company’s 409A/common stock value approaches the preferred share value.
- Granting RSUs can also reduce cap table dilution, which is often a growing concern among VC’s and other preferred shareholders.
- Finally, RSUs are often considered “lower risk” during periods of economic volatility (like the last year during COVID-19). Sudden valuation declines can lead to instances of underwater options, where equity grants have zero value as the option strike price drops below the common share. RSUs, on the other hand, always retain some value because there is no strike price — they behave the same as a share of common stock.
RSUs can also present some unique challenges for private companies.
- RSUs introduce challenges with employee tax treatment. Since an employee doesn’t own their RSUs until they fully vest, they are not eligible to receive long-term capital gains treatment when they are initially granted. Shareholders also have no control over when that tax bill arrives, whereas the exercise windows provide greater flexibility with options.
- RSU shareholders must pay that tax out of pocket as soon as they vest. That typically isn’t an issue in the public markets because an RSU holder can simply sell a portion of their holdings to cover the tax bill. However, within private companies, RSU holders cannot liquidate a portion of their holdings if they vest before a liquidity event. Most companies are hesitant to place the tax liability burden directly on their employees – especially if the RSUs vest while the company is still private – which is why companies opt for “double trigger” vesting, whereby RSUs vest based on a time-based schedule and only after a subsequent exit event. Shareholders (or the company, if it is buybacking the tax liability) are then taxed on the fully-vested shares at the stock’s current value.
RSUs can be tricky if the company has an uncertain timeline for their liquidity event. This is why timing is absolutely critical to the decision to transition from options to RSUs.
When to Consider Transitioning to RSUs
According to our experts, the ideal time to start transitioning from options to RSUs is around 6-12 months out from a liquidity event. Having that certain timeline is critical because again, RSUs are heavily impacted by the timing of your exit. Suppose your company has no immediate plans to go public. In that case, you’ll want to think carefully about the implications of granting RSUs that won’t fully vest before a liquidity event to avoid having employees incur a tax liability in illiquid security.
Another trigger for when it may make sense to think about transitioning to RSUs is when your company’s 409A valuation exceeds 50% of the last preferred round option pricing. At this point, the Discount for Lack of Marketability (DLOM) will be lower, offering less upside value for new option holders.
Another often-overlooked consideration for transitioning to RSUs is if your company is issuing more than $10 million in equity grants annually. Doing this will trigger additional financial disclosures required under SEC Rule 701. If this happens, your company needs to provide more detailed financials and risk factors to shareholders (like a public company) once this threshold is reached.
How to Effectively Manage the Transition
Once you’ve decided to transition over to granting RSUs, you’ll need to consider a few different factors.
- Are you transitioning completely to RSUs or a mix of RSUs and options? Our experts agreed that the decision really depends on the unique circumstances of your company. It is common to see companies start with a 50/50 split of RSUs and options for executives. However, it may be a more swift transition to all RSUs for the bulk of employees for most companies. It is also increasingly common for companies to issue “performance-based” RSUs, which are RSUs that only vest after multi-year performance targets have been met. Transitioning to these “PRSUs” can help align employee incentives post-IPO and also quell some of the pushback from VC’s and institutional investors that disapprove of the non-performative nature of RSU grants.
- What happens to vested RSUs held by an employee that leaves the company prior to an exit event? In other words, will that employee lose their RSUs entirely or have the option to keep them? The key to this decision is striking a balance between not forcing employees to forfeit the value of their equity and not diluting the retentive value of your RSUs. After all, the goal of your RSU grants is to ensure employees stay aligned with the company’s growth leading up to and after an exit event. Our experts agreed that there’s no right or wrong answer here; it really comes down to understanding the growth and churn of your employees and matching your strategy accordingly.
- How will you communicate the shift to your employees? Introducing RSUs, whether as a new equity grant or through an option exchange, can impact your employees’ perception of their equity. On the surface, employees may see RSU grants as a reduction in the value of their equity. This is why it is important to educate them on the decision to switch, and how it can benefit them with both a lower downside risk and a simpler way to calculate the value of your holdings. You’ll want to focus extra attention on helping them understand the tax implications of holding RSUs versus options so that they can plan accordingly.
The general consensus from our experts was that transitioning from options to RSUs is a complicated and nuanced decision that requires coordination between your finance, HR and legal teams. Taking a more proactive and deliberate strategy as you approach a later stage valuation can help you really think through the timing and rollout strategy of your transition in order to optimize for success.
If you’re a CFO facing similar decisions about your equity strategy, we encourage you to apply to join The Circle, where we curate content and conversations for growth stage executives across 200+ private companies.