Ward: Let’s say a company has a run-up in value. The company goes from its early valuations of $5 million to $30 million to $120 million to $700 million, as we have seen happen a bunch of times.
If a company’s value starts to flatten—from $700 million to $750 million—the incentivizing effect of options is muted. At these higher valuations, companies start to think about alternatives like RSUs (restricted stock units).
With a restricted stock unit, the employee doesn’t own any property. You just have the right to receive the value of a share of stock upon the occurrence of certain events.
It’s a derivative instrument, unlike restricted stock, so it has less advantaged tax treatment. With restricted stock, you own the stock outright and if you met the statutory holding periods when you sell the stock, you get long-term capital gains treatment on the gain. With an RSU, on the other hand, you’re not eligible to receive long-term capital gains treatment based on when the RSU was granted because you don’t own stock when the RSU is granted. You only receive stock and start your holding period for long-term capital gains purposes when the RSU vests.
Lisa: An RSU is really a promise for an employee to get a share of stock (or sometimes, its cash value) in the future. Although they’re the least tax advantaged form of equity comp we’re talking about today, they can be attractive in later stage companies because they don’t have an exercise price or purchase price and also don’t have any up front tax consequences.
RSUs have been around for a long time in public companies, and in a public company, they typically just have time or service-based vesting. When you’ve worked for the company for a year, 25 percent of your RSUs might vest, and you would get a certain number of shares of stock at settlement. Like I said before, when you get shares of stock from your employer, you owe tax on that.
In a public company, when your RSUs vest and you get a tax bill, you just go ahead and sell some of the shares that you just got in the public market, and use the cash you’re paid from the buyer to pay your taxes. In a private company, that doesn’t work because there’s no market for those shares. If your RSU were to vest while the company is private, you couldn’t easily sell shares to cover your taxes and you couldn’t plan ahead to set aside money for taxes because you don’t know what those taxes will be. Your taxes will be based on the value when the RSUs vest and are converted into shares that you own. So when those RSUs are granted to you today, maybe the company is worth $100 million.
When they vest and settle a year from now, it might be worth $150 million but you won’t know that in advance, so you can’t prepare for the tax bill.
One way private companies have gotten around this problem is to require an exit event for the RSUs to vest. That way the employee isn’t taxed until she can sell shares, or the shares otherwise become liquid, to cover the taxes.