Private companies often switch their employee equity programs from stock options to restricted stock units (RSUs) when they reach the later stages of growth. On average, companies that make the switch do it when they reach a post-money valuation of $1.05 billion.
Why companies switch to RSUs
Companies switch to RSUs for a few reasons:
RSUs help companies offer compensation and benefits packages that are competitive not only with other private companies, but with public companies as well, if the company uses RSUs in conjunction with a planned liquidity program.
RSUs can be less dilutive to a company than a comparable option grant. Companies will often give employees more shares under a stock option program than they would under an RSU program, to offset the exercise price of an option. (Or, if the company settles employee RSUs in cash, no stock is ever issued or added to the capitalization table.)
RSUs make equity ownership more accessible to employees because there are no out-of-pocket costs for employees to take ownership of their stock award.
As a private company grows and raises capital at higher post-money valuations, the fair market value (FMV) of its common stock rises. This rising FMV is then reflected in the strike price of the company’s stock options—the price employees have to pay per share to exercise their options. Eventually, the strike price at a high-valuation private company becomes prohibitively expensive for many employees.
When the strike price of stock options increases to a price most employees can’t afford, equity compensation isn’t as motivating to employees, because they might never consider purchasing the stock they vest. At this point, RSUs start to make more sense.
Unlike stock options, RSU grants don’t require employees to pay anything out of pocket to become owners of the shares from their award. Instead, employees pay supplemental income tax on the current FMV of the stock when they acquire their shares (similar to taxes on cash bonuses).
RSUs typically have conditions that need to be met to vest. Once they do, the units are eligible for settlement by the company, which is when the employee legally gains possession of the shares. The employee must pay taxes on RSU income in the year the RSUs settle.
Private companies have two options—involving “single-trigger” or “double-trigger” RSU awards—to help employees cover those taxes:
Restrict full vesting until an exit event, at which point the employee can receive payment for their stock in an acquisition or sell enough stock on the public market to cover the applicable taxes. This is easily done with a double-trigger RSU award.
Allow vesting without an exit event, but separate vesting from settlement to control the timing of both the settlement and the subsequent tax obligation. This can be done with a single-trigger RSU.
What are double-trigger RSUs?
For double-trigger RSUs, the first vesting condition is a time-based schedule that sets out how employees “earn” their shares over a period of time they work at the company. The most common time-based vesting schedule in the tech industry occurs monthly over four years, with a one-year cliff (an initial time period the employee must work at the company for any shares to vest). Typically, the second vesting condition is an exit event: The company must go through an IPO or acquisition for an employee to gain full ownership of their time-vested shares.
Double-trigger RSU disadvantages
Although the double-trigger RSU model has historically been more common for private companies, it comes with downsides for employees. The liquidity vesting condition essentially blocks double-trigger RSU holders from participating in private market liquidity because a secondary liquidity transaction (such as a tender offer) doesn’t count as the second vesting condition. Double-trigger RSUs can also lock employees out of the value of their equity compensation when companies attach additional stipulations to the award. For example, many employers attach a “must be present to win” condition on the double-trigger RSUs in the employee’s RSU award, which restricts the second trigger to only current employees at the time of the exit event. An employee who leaves the company before the exit event takes place will lose all of the equity in their compensation package.
Waiving the second trigger
To help employees realize the value of their equity, companies that assign double-trigger vesting to RSUs may later decide to offer secondary liquidity to RSU holders before the second liquidity condition is met. To do so, they’ll need to issue a partial waiver of the liquidity vesting condition.
When a company waives the liquidity vesting condition, employees who hold vested RSUs can settle and sell their stock for cash (as long as the terms of their award allow them to sell those shares), and then cover the applicable tax obligation with cash. However, waiving the second condition is something a company can only do once without triggering immediate income tax consequences for all time-vested RSUs that have only met the first trigger.
Double-trigger RSU taxation
For RSU grantees to defer income taxes until vesting is complete, the IRS requires that there be “substantial risk of forfeiture.” That means there has to be a possibility that grantees won’t actually vest their RSUs. With typical double-trigger vesting, “substantial risk” could include the chance of the company failing, the employee not being “present to win” because they have left the company, or the company never having a liquidity event. But if a company issues multiple waivers of the second trigger, the IRS will likely view it as removing that risk for all RSUs—even if the waivers don’t actually apply to all RSUs. In other words, the IRS will consider all time-vested RSUs as compensation income. All holders of time-vested RSUs would then owe supplemental income tax on the value of those RSUs—even those who decide not to participate in the secondary liquidity transaction.
If your company decides to waive the second trigger, you should carefully consider the terms of the liquidity event, the tax risk, the company’s cash on hand, and which RSU holders are eligible for the waiver. Eligible RSU holders can’t choose whether or not to waive the liquidity vesting condition themselves: The company must decide, and the decision will affect all time-vested RSUs.
If your company wants to switch to RSUs to help build employee ownership, but you’re not planning an exit soon, single-trigger RSUs may be the better fit.
What are single-trigger RSUs?
Unlike double-trigger RSUs, single-trigger RSUs don’t require an exit event to fully vest—they have only a time-based vesting condition. Employees are able to settle their RSUs into shares as they vest. If the company offers private market secondary transactions, employees can then sell their shares to private market investors without waiting for a second trigger.
Solving the tax issue
So why aren’t single-trigger RSUs the default? It’s mainly due to tax implications.
RSUs are taxed as supplemental income to the employee at the time they vest. In the case of double-trigger RSUs, employees gain liquidity at the same time their shares vest and settle, so they can use the cash from an immediate sale of some of their shares to cover the taxes they owe.
In the case of single-trigger RSUs, employees owe income taxes on the RSUs in the tax year the RSUs settle. But depending on when company liquidity events occur, they may not have the cash on hand to cover the taxes.
Net settlement for RSUs
To help employees cover the taxes due on settled RSUs, Carta uses net settlement. This means that when an employee’s RSUs settle, Carta will hold back a certain number of shares (based on the employee’s tax rate) equal to the taxes that would be owed on the shares. The employee then receives the balance of their shares of company stock and doesn’t have to pay any additional income tax on the shares to the IRS.
Net settlement comes at a cost to the company, which has to use cash off the balance sheet to actually pay the taxes that would otherwise be owed by the employee at vesting. But it makes an RSU program much simpler and more attractive to employees. With net settlement, taxes on employee RSUs will look and feel similar to how salary compensation works: What you receive is what you’ve earned, minus withholding for taxes, which your company coordinates on your behalf. However, the difference from cash salary is that the employee will later be able to capture any growth in value of the shares they receive.
Although this unique structure requires coordination and planning, we believe the benefits of stock ownership that single-trigger RSUs enable outweigh the downsides. When employees are able to realize the value of their equity compensation while still working for the company, their equity ownership is more meaningful. This can make the company more competitive in hiring and more successful at retaining talent. It also aligns employee incentives with company goals and value creation.
How can I set up single-trigger RSUs?
If you’re considering switching to RSUs, ask your company’s law firm about single-trigger RSUs designed with private market liquidity in mind. If you’re wondering if it’s the right time to switch to RSUs: check out Carta’s free option and RSU grant calculator to compare.
For more information on RSUs and optimizing your company’s private market liquidity options, reach out to Carta’s Jackie Ammon for consultation.
DISCLOSURE: This communication is on behalf of eShares Inc., d/b/a Carta Inc. (“Carta”). This communication is for informational purposes only, and contains general information only. Carta is not, by means of this communication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests. Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein. ©2022 eShares Inc., d/b/a Carta Inc. (“Carta”). All rights reserved. Reproduction prohibited.