RSUs - Restricted Stock Units - Evaluating an RSU Offer at a Startup
Working for a startup? Here’s how to think about Restricted Stock Units or RSUs.
Originally published February 10, 2014. Updated March 27, 2017 and July 5, 2023.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Working for a startup? Here’s how to think about RSUs.
What are RSUs?
Restricted Stock Units ("RSUs") are not stock. They are not restricted stock. They are not stock options. RSUs are a company's promise to give you shares of the company's stock (or the cash value of the company's stock) at some time in the future.
How Many Shares Do I Have?
One RSU is equivalent to one share of stock. The number of RSUs in your grant determines how many shares of stock (or the number of shares of stock used to determine your cash payment) you will receive when they are "settled" on the Settlement Date.
You’ll receive one share of stock (or the cash value of one share of stock) for every vested RSU on the Settlement Date. For startup (private company) RSUs, the Settlement Date is usually a company Liquidity Event. A company Liquidity Event might include (i) a Change of Control (aka Merger or Acquisition); (ii) after an IPO, when post-IPO lockup on employee sales expires or (iii) a company choice to have an early settlement in shares.
When are Startup RSUs Taxed?
Most startup RSUs are structured elegantly to defer taxes until after the shares can be sold to cover the taxes. That’s achieved with a two-tier vesting schedule. Before the RSUs fully vest (so they can be “settled” in shares or cash on the Settlement Date), two triggers must be met:
Time-Based Vesting AND
Liquidity-Event-Based Vesting
Time-based vesting is the classic vesting concept. You will meet the time-based vesting requirement over a set period of time of service (called the "Vesting Period"). The most common time- vesting period is quarterly vesting over four years with a 1-year cliff.
The liquidity-event vesting requirement is the tax-deferral concept. The shares will not be settled / fully vested for tax purposes until the company has a Liquidity Event. A company Liquidity Event might include (i) a Change of Control (aka Merger or Acquisition); (ii) after an IPO, when post-IPO lockup on employee sales expires or (iii) a company choice to have an early settlement in shares.
Without this liquidity-event vesting requirement, RSUs could become vested for tax purposes before there is a market to sell the shares (or even before shares are officially received in exchange for the RSUs at settlement). That would be very unappealing for startup employees and executives, as they would need to pay taxes out of their own funds based on the FMV on the vesting date.
[Careful! This two-tier vesting structure (sometimes called double trigger vesting) is a tax deferral mechanism. It is not the same thing as double trigger acceleration upon change of control! Those are often confused so be careful there.]
Do Startup RSUs Expire?
Yes! There’s two issues to watch out for w/r/t expiration / forfeiture of startup RSUs.
All startup RSUs include a deadline, so that if the Liquidity Event is not achieved by a certain date, all RSUs will be forfeited without payment. That is usually 5 or 7 years from the date of grant. Therefore, most RSUs are designed to be forfeited if the company does not go public or get acquired within 5 or 7 years of the employee or executive’s start date even if the RSUs have already time-vested by that date. Unfortunately, this term is not negotiable as it is a tax-driven deadline. The RSUs must be designed with a substantial risk of forfeiture in order to defer taxation.
In addition to this tax-driven deadline, some RSUs include a forfeiture clause. This is similar to the dreaded clawback for vested shares, even though it is technically part of the vesting schedule. Here’s how it works. If an employee or executive leaves the company, they forfeit any time-vested RSUs that have not yet been settled / vested at a Liquidity Event. In other words, the employee or executive has to survive all the way through a Liquidity Event to get anything for their time-vested RSUs. This type of forfeiture term greatly reduces the value of an RSU grant because it is not really "earned" even after the time-based vesting period.
Will I Receive Annual Refresh Grants of Startup RSUs?
Probably not! Most private companies do not make substantial refresh grants either annually or at the time of future financings. In my experience, approximately 90% of the equity individuals receive at startups is in their original, at-hire grant. This likely would be refreshed only after it is close to meeting its full time-vesting requirements.
This is usually a surprise to employees and executives coming from public companies, where regular refreshes are the norm. The reason for the difference is that startups are hoping for huge increases in valuation. If that happens, the original grant would be sufficiently valuable to retain employees and executives. If you are evaluating a job offer, there is a big difference in the value of your offer between a company that grants RSUs only at hire (and after they have vested) and a company that plans to make additional refresh grants regularly.
How Do I Value Startup RSUs?
There is no precise "value" for startup RSUs since they are not liquid (aka easily sold). But employees and executives who are evaluating startup RSUs offers do think about value when their considering how much equity makes sense for their role.
When evaluating the number of RSUs in an RSU grant, employees and executives use one or both of these approaches:
Current Valuation Method (Fact-Based): For startup stock, most hires use the price per share paid by venture capitalists for one share of preferred stock in the most recent financing as a proxy for the value of their RSUs. This is the closest number you can find for today's value. It tells you that X Venture Capitalist paid $Y for one share of the company's stock on Z date. The usefulness of this approach is somewhat limited for stale valuations, especially in the 2022-2023 market. For more on this approach, see Venture Hacks' post on startup job offers.
Percentage Ownership: Executive hires also consider their percentage ownership compared to market for their role at this stage of company. Individuals often struggle to find good resources for startup compensation data since subscriptions to the primary startup compensation data sources are only available on the company side. Here’s a blog post with publicly-available startup compensation data links that readers have found helpful.
Future Valuation Method (Guesstimate Based): To look forward and define a future payout for your RSUs, you have to do some guesswork. If you could guess the startup's value at exit and dilution prior to exit, you would know how much the stock will be worth when you receive it at settlement/post-IPO. Be careful, though, not to use price/share in isolation as stock splits would affect that in unpredictable ways.
Employees and executives often consider these facts to build those approaches of analysis:
Recent VC price per share of preferred stock
Current number of fully diluted shares in the company or the offered percentage ownership in the company
Possibilities around expected dilution, exit scenarios, exit timing and future valuation?
Need More Info?
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Startup Stock Options | Post Termination Exercise Period | Examples of Good Startup Equity Design by Company Stage
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Originally published August 11, 2017. Updated March 17, 2023.
It’s helpful for startup employees to understand early expiration of stock options and the possible solution of a full 10 year post-termination exercise period. But the full 10 year term stock option is not the right design for every startup equity grant! In some cases it would be the wrong ask, and pushing for it can can lead to embarrassment or a disadvantageous design.
Examples of Good Startup Equity Design by Company Stage
I work with individual clients to balance their priorities for investment timing, tax timing, tax rates and value structure. These are some examples of how the trade-offs are made at each stage. You can also read more about option exercise strategies here in the Menu of Stock Option Exercise Strategies.
1. Earliest Stage - Startup Restricted Stock Purchase
While a startup is in its early stages and its Fair Market Value (FMV) is quite low, consider purchase of Restricted Stock for founders and early employees. This is the model used for Founders’ Stock at startups, and it is also ideal for executives and employees who are willing to pay the FMV of the common stock up-front for their shares. With the use of an 83(b) election with the IRS, Restricted Stock purchase provides for tax deferral until sale of stock, favorable capital gains tax rates at sale of stock, and fewer tax penalties than stock options in the event the IRS determines the FMV was underpriced for the shares.
2. Early to Mid-Stage - Early Exercise of Startup Stock Options
For those who are willing to take early investment risks for tax deferral and lower tax rates, consider early exercise of stock options. This is an obvious choice for early-stage startup hires who can afford the stock purchase price at hire. For example, at a very early stage startup an employee’s total exercise price might be less than $1,000. Early exercise may also be a good choice for some individuals at mid-stage startups with somewhat higher exercise prices or even later stage startups with high growth potential, as an early investment may be worth it for future tax savings and/or tax deferral.
Early exercise stock options can be exercised before vesting. If they are exercised before the FMV rises above the exercise price, tax payments are deferred until sale of stock by use of a Section 83(b) election at the time of purchase.
However, the investment risk is real, as the purchase price is delivered up-front and shares are held as an investment. If the shares were to become worthless, the investment amount would be lost for both vested and unvested shares.
Early exercise stock options are preferable to restricted stock if the employee is not sure about making the investment up-front. Unlike the purchase of restricted stock, the choice to exercise stock options (even with early exercise rights) can be deferred for some time. However, if the exercise or early exercise is made after the FMV has gone up, the exercise will lead to taxable income.
The early exercise structure can be combined with an extended exercise period (see below under #3 or more here on the blog), so that the employee has the choice between early exercising to minimize tax rates or deferring exercise until any time within the full 10 year term.
Note that the right to early exercise can be a disadvantage for stock option grants with an exercise price greater than $100,000 if they are not early exercised. Any amounts over $100,000 would be ineligible for ISO status due to the ISO rules’ $100,000 limitation.
3. Early to Mid-Stage - Stock Options with Full 10-Year Exercise Period
While there is still potential for high growth in value, stock options are an advantage for employees. However, a high exercise price or a high tax bill at exercise can make it impossible for employees to take advantage of the value of stock options. This is because stock options have traditionally been granted with a disadvantageous early expiration term requiring exercise within three months of an optionee’s termination date. Therefore, stock options are most advantageous where they are granted with a full 10 year term to exercise regardless of the date of termination. This allows the optionee to defer the investment decision and the associated tax bill for exercise.
Additional consideration: Optionees who take advantage of an extended exercise period (exercise their options after 90 days from last employment) lose their Incentive Stock Option (ISO) tax treatment. Shares exercised after 90 days from last employment will be treated as Non-Qualified Stock Options (NQSOs) and generally come with a higher tax rate. However, with this extended exercise design, optionees can choose to exercise within 90 days and keep their ISO classification, or wait to exercise and accept the NQSO classification. This flexibility is key in rewarding optionees of all types and financial circumstance.
4. Later Stage - Restricted Stock Units
Employees may prefer RSUs to stock options at later stage companies for both tax deferral and offer value purposes. Well-designed RSUs defer taxes until liquidity so long as it is within a certain time frame (such as 7 years from the date of grant). RSUs are less advantageous for tax rates, though, as the value of the shares is taxed as ordinary income at settlement. RSUs are advantageous from an investment perspective because there is no investment risk as there would be in a stock option exercise prior to liquidity. RSUs also give the employee the full value of the shares at liquidity as there is no purchase price to pay for the stock as there would be with a stock option exercise price. For this reason, a grant of RSUs generally consists of fewer shares than a grant of stock options at a company of the same stage.
Wrapping Up
This is Part 3 of a 3-part series on the startup scene’s debate about early expiration stock options. See Early Expiration of Startup Stock Options - Part 1 - The $1 Million Problem for more information on the issue and Early Expiration of Startup Stock Options - Part 2 - The Full 10-Year Term Solution for more information on the full 10-year term solution.
Thank you to attorney Augie Rakow, a partner at Orrick who advises startups and investors, for sharing his creative solution to this problem in Early Expiration of Startup Stock Options - Part 2 - The Full 10-Year Term Solution.
Thank you to JD McCullough for edits to this post. JD is a health tech entrepreneur, interested in connecting and improving businesses, products, and people.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
The Myth of Startup Employee Equity
Working for a startup? Break through the myth of startup equity to make the most of your equity compensation offer. Photo by Startup Stock Photos.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
The shiny myth of startup equity has incredible power to recruit and retain talent. This is the myth:
If you have any startup equity, and the company is a success, you will be rich!
All startup equity contracts are “boilerplate,” so whatever fine print you sign, you will be rich!
You never have to make an investment in or pay taxes on startup equity until you are already rich!
The duller reality of employee equity conflicts with this myth. Here’s my take on this “reality”:
The number of shares in the original job offer will determine whether the potential upside will balance the financial risk in joining a startup.
The fine print terms affect the potential value of any startup equity offer (especially the consequences of a termination of employment prior to a company exit event).
Standard tax structures for employee equity often require individuals to choose between forfeiting vested stock options and making a significant personal investment in the shares (to cover the exercise price and associated taxes) prior to having access to liquidity for the shares.
Most employees believe the myth, so they do not bother to ask questions and learn more about the reality of their equity offers. In this context:
The shiny myth of startup equity does the job of recruiting and retaining employees without any action on the part of the company. Companies can follow the classic sales advice - “Never give someone more information than they need to make a decision.” - and let the myth fill in the gaps. If they don’t ask, why tell?
Only those few companies with extraordinarily favorable employee equity programs have any incentive to educate their employees to see the difference between their plans and their competitors’ plans. That incentive may be minimal, though, as such an education may even disincentivize employees from joining startups with favorable programs. The reality of even the most favorable programs cannot compete with the myth of magical riches.
Those companies with unfavorable terms in their employee equity programs would have zero incentive to provide such an education. Their financial models could not likely be sustained if their employees were knowledgeable about the terms from the start. For example, one prominent late-stage startup with a 3-month post-termination option exercise deadline relies on a model that only 15% of vested options will be exercised. As my colleague commented, the terms that bust the myth would be a feature, not a bug, for such a company.
I would love to hear that I am wrong in my assessment. I would much prefer to be sharing success stories of company-side equity education programs and explaining why startup companies actually do need to educate their employees in order to effectively recruit and retain them with equity. Please comment below!
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Part 2 - Examples of a Clawback Clause for Startup Stock
Working for a startup? Learn how a clawback clause, forfeiture term or repurchase right limits the value of startup equity. Plan ahead to protect your equity stake.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
What is a Clawback Clause?
Startup hires expect that they will be able to keep their vested shares if they leave the company before an exit event. That’s not always the case. Learn more in Part 1 of this series - Clawbacks for Startup Stock - Can I Keep What I Think I Own - about how a clawback clause limits the value of startup equity.
In this post, we will share some examples of a clawback clauses or clawback provision that would allow startups to take back vested shares or options.
What is an Example of a Clawback Clause?
Equity Incentive Plan I
The company reserves the right to include clawbacks for vested shares upon an individual's termination of employment:
Repurchase Right. The Company (and other designated Persons) may repurchase any or all of the shares of Stock granted to a Participant pursuant to an Award or acquired by the Participant pursuant to the exercise of a Stock Option upon such Participant’s termination of employment with, or Service to, the Company for any reason to the extent such a right is provided in an Award Agreement or other applicable agreement between the Company and the Participant.
Such terms could be included in any agreement with the individual, such as a Stock Option Grant Notice, a Stock Option Agreement, a Stock Option Exercise Agreement, a Termination and Release or Severance Agreement, a Restricted Stock Agreement, an RSU Agreement, an Employment or IP Agreement, or a Stockholders' Agreement.
Equity Incentive Plan II
The company reserves the right to implement a policy in the future to clawback vested or unvested shares, and you’re agreeing that such a change will apply retroactively to your shares:
Clawback Policy. The Awards granted under this Plan are subject to the terms of the Corporation’s recoupment, clawback or similar policy as it may be in effect from time to time, as well as any similar provisions of applicable law, any of which could in certain circumstances require repayment or forfeiture of Awards or any shares of Common Stock or other cash or property received with respect to the Awards (including any value received from a disposition of the shares acquired upon payment of the Awards).
Stock Option Agreement
The company reserves the right to change its bylaws in the future to clawback vested or unvested shares, and you’re agreeing that such a change will apply retroactively to your shares:
Right of Repurchase. To the extent provided in the Company’s bylaws in effect at such time the Company elects to exercise its right, the Company will have the right to repurchase all or any part of the shares of Common Stock you acquire pursuant to the exercise of your option.
These two terms allowing retroactive changes push the limits of Delaware law on company repurchase rights. However, I advise my clients to negotiate these out of their documents before joining a company to avoid litigation at a later date.
Restricted Stock Unit Grant Notice
In order to vest RSUs, the time-based vesting requirement (the "Time Condition") must be met, and the Company must have an IPO or a Change of Control (the "Performance Vesting") prior to the 7 year expiration period of the RSU. This is a normal structure for a startup RSU grant due to tax planning. However, in this example, if the IPO or Change of Control does not occur by the individual's last date of employment, the RSUs are cancelled and never vest:
Vesting Conditions. Any Restricted Stock Units that have satisfied the Time Condition as of such date shall remain subject to the Performance Vesting set forth in Section 2(b) above, but shall expire and be of no further force or effect on the first to occur of (a) the date on which the Grantee’s Service Relationship with the Company terminates, or (b) the Expiration Date.
Employment and Confidentiality Agreement
The company reserves the right to terminate vested options in the event of a breach of the agreement:
Breach of Confidentiality Agreement. If the Optionee breaches the provisions of the Confidentiality Agreement, then any outstanding Options held by such Optionee at the actual time of such termination shall thereupon expire, terminate and be cancelled in respect of all vested and unvested Option Shares.
Breach of Non-Competition and Non-Solicitation Covenant. If the Optionee breaches the Non-Competition and Non-Solicitation Agreement, then any outstanding Options held by such Optionee at the actual time of such termination shall thereupon expire, terminate and be cancelled in respect of all vested or unvested Option Shares.
While these two examples from employment and confidentiality agreements apply to restrictions on exercising options, similar terms may also apply to repurchase or forfeiture of vested shares for violations of such agreements even after termination of employment. More on this here from the National Association of Stock Plan Professionals in June 2023.
Other Clawback Clauses
These are only a few examples of how clawbacks might appear in an equity offer. There are more ways they can appear in the fine print. And, practically, an option exercise deadline acts as a clawback as well. Having only 3 months to exercise options is a standard market term, but it often acts to prevent employees and executives from exercising their vested shares. More on this in:
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Thank you!
Thank you to JD McCullough for editing this post. He is a health tech entrepreneur, interested in connecting and improving businesses, products, and people.
Seed Stage Startup Job Offer - Equity Negotiation Checklist
Working for a Startup? Seed Stage Startup Job Offer Equity Compensation Negotiation Checklist. Image from rawpixel.com.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Have a job offer from a seed stage startup? Individuals work for equity at seed stage startups (otherwise known as early stage startups) with the expectation that they will have great financial success if the company itself is successful. That dream can come true, but it depends on taking care of a few key details of the option or restricted stock at the offer negotiation stage. Here’s the Stock Option Counsel negotiation checklist for seed stage startup offer negotiations.
Percentage Ownership. The lore of Silicon Valley is that anyone who joins an early stage startup that is later a huge success will become rich. But if they fail to negotiate a significant number of shares at hire, they cannot expect that the value of their interest at the time of an acquisition or IPO will be impressive. Since being one of the first startup employees is extremely risky, there needs to be enough equity in the offer to balance that risk. I have seen individuals who are disappointed (to say the least) in these situations when they have accepted a below-market equity percentage and assumed that the founders would “take care of them” in the future. With these points in mind, I recommend taking the following steps before agreeing to join a startup:
Negotiate for enough shares up-front to balance the risk in joining the company. This is based on market norms, so do plenty of research among colleagues and advisors to confidently set market-based expectations.
Insist on time-based, not performance or milestone, vesting.
Expect that the equity interest will be significantly diluted and negotiate for enough shares to cover that expectation.
Making it Official. At the earliest stage startups, employees and founders often work for promises of future equity without signing the necessary paperwork to ensure that they have the legal right to that equity. They often start working with vague promises of future grants and “trust” that their business partners will “take care of them” in the future. This is misguided, as the purpose of a stock option grant or any written agreement is to not have to rely solely on the trust you have in any individual person. Since changes in leadership, investors, direction, etc. are guaranteed to happen at some point in time, you need protection from the company not promises from the current leaders. Before signing an Offer Letter or beginning work, I suggest to first:
Ask for a copy of the Form of Stock Option Grant or Restricted Stock Purchase Agreement, along with any other documents referenced therein. Review the terms and negotiate any issues.
Ask the company to confirm that the board will officially make the equity grant promptly after hire.
Board Approval Timing. Early stage startup companies often delay officially making grants to the detriment of their employees. This is due to administrative disorganization, a desire to delay the legal and valuation expenses of making the grant, or even a disagreement among executives and investors about how much equity should be allocated for employee grants. After starting in the role, take the following steps:
Follow up to be sure the grant is made by the board promptly. This should not take more than a couple of months.
Compare the terms of the grant to be sure they are as-agreed during the offer negotiation stage.
Tax Planning. The potential tax benefits to receiving equity in an early stage startup are unparallelled. The structure may allow for tax deferral until sale of stock - which avoids the problem of paying taxes on option exercise before liquidity - and lower capital gains tax rates or even 0% QSBS tax rates on gains. Achieving these tax benefits requires precise design by the company - such as restricted stock or early exercised stock options - and effective execution by the individual - such as the timely delivery of the purchase price and filing of the Section 83(b) election with the IRS. Early tax planning action items are:
Negotiate the tax structure during the offer negotiation stage. The right structure will depend on the stage of the company, so work with advisors if necessary to determine the most desirable structure for your grant.
Take care of the required follow-through to take advantage of the most desirable tax structures.
Legal Terms. Startup employees are sometimes very surprised by the legal terms in their grant years after they have accepted its terms. They might have assumed that they have the right to hold the shares that they have purchased and vested and find out that the company can forcibly repurchase the shares at their termination. Or they might assume that they have the right to earn their unvested shares following an acquisition but find out that they can be cancelled as part of the deal without payment. To avoid these and other unpleasant surprises regarding the legal terms of a grant, take the following steps during negotiation:
Ask for a copy of the Form of Stock Option Grant or Restricted Stock Purchase Agreement, along with any other documents referenced therein.
Review the terms and negotiate any issues before committing to joining.
If the legal terms have unexpected risks, negotiate for more shares or more cash compensation to balance the risk.
Have an offer from a seed stage startup? Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.