Considering the author's previous article was about how employees do not deserve to keep their equity unless they stay with a company until liquidity, I suspect he would not support granting restricted stock.

http://a16z.com/2016/07/26/options-plan/

If they didn't deserve it, then they shouldn't be compensating the employees with equity & should be doing so with cash.

Can't have it both ways.

(This is more of a response to the link, not your comment in particular)

Well, having it both ways is entirely dependent on market forces. As of right now, it would seem they can in fact have it both ways.

always depends what employees are willing to do.

Which is what Parent meant by market forces.

  > Can't have it both ways.

See the "participating" section of the article on preference, where the investor can in fact have it both ways.

I'm not sure I quite get what you mean by "issuing early employees restricted stock awards". Can you elaborate? Is this like an IOU for restricted stock? Isn't that kind of like what stock options are (except for common stock)? And if you just mean giving actual restricted stock (like to investors), then the main problem is you have to pay those taxes right away (the whole point of options). But maybe you mean something else.

Sort of. With restricted stock, the stock is not transferable from the company to you until certain conditions are met. The grant has been made, but the shares aren't yours until they vest (conditions met). I believe (I'm not a tax lawyer) that you pay taxes on the fair market value of the stock as of the vesting date, but you can elect to pay those taxes on the date of the grant instead, based on the value of those shares on that date (with the risk being that if the shares never vest, you don't get your tax money back).

Then there are RSUs - restricted stock units. This is more like an IOU in that the company promises now to grant you a block of restricted stock at some point in the future. It's to manage taxation, and again, that's less my area. A good explanation is here:

http://avc.com/2010/11/employee-equity-restricted-stock-and-...

If you are granted restricted stock subject to vesting, in the US you owe taxes only when the stock is both released AND vested, meaning the tax bill comes due in stages as the shares vest, not "right away". If you give restricted shares that vest over time and are only released upon a change in control, you can further defer the tax bill due date (though at the expense of the eventual bill being higher on average).

Most restricted stock subject to vesting will require the recipient to file an 83(b) election. This takes the full current value of all shares at the current issue price as income up front. Since the shares are typically worthless at that point, the tax bill is zero.

The alternative is disastrous for a fast growing company. Each month, each year, you are vesting new shares at an exponentially increasing valuation, and now have to pay income tax on that completely illiquid gain with cash you literally don't have.

> Most restricted stock subject to vesting will require the recipient to file an 83(b) election

No RSU grant "requires" an 83(b) election.

Your second point is why RSU grants with normal vesting and delayed release is desirable.

I've personally written restricted stock grants which require 83(b) elections to be filed. My understanding is that is boilerplate in the Restricted Stock Purchase Agreement.

Please note, Restricted Stock !== RSU, and RSUs are not eligible for 83(b) because they are just a promise of future shares, no stock is actually issued until the conditions are met. (see above)

If that's the case, do you require employees to pay for their shares at grant date? Otherwise it's a taxable event (not cap gains but real income) when they vest.

Or do you "sell" a portion of the shares back to the company to pay taxes for the employee, then the employee gets 45-50% the number of shares that are vested. This is what Microsoft did when I was there, but they were publicly traded and had a public market to "sell" into (though it went straight to company stock buyback plan). Private companies don't have that luxury and would have to pay real money to the IRS to foot employees' tax bills at various vesting dates.

If it's restricted stock, either the grant is taxable income, or the stock is paid for at the time of the grant (write a check to the company). Vesting is then defined a reducing percentage of shares the company can buy back over time, and so if the employee leaves or vesting terminates for some reason, the company writes a check to cover the refund.

This all works best in the early days when the 409a valuation is zero. Once you have a high valuation, getting real amounts of equity into employee hands that has a good chance of actually being valuable in the future is extremely difficult, because with each share you give to an employee you are giving essentially 40-50% of that to Fed + State, plus another 30% of any future gain. Since this is all based on fantasy valuations of an illiquid asset, it is playing with fire in the worst way.

The only other option is options with high exercise prices based on highly speculative earnings forecasts, for shares which are 2nd or 3rd in line behind all the preferred stockholders. This might work out for late hires at Google and Facebook, but almost never anywhere else.

I mean think about it -- "Here are some common shares of my company; I just raised $50m at a $500m valuation, we are burning $5 - $10m in cash every quarter. We are are going to be absolutely massively huge and a billion dollar unicorn in no time. There are currently $100m of preferences ahead of you, and we will certainly need to raise huge amounts of more cash in the years ahead to achieve our vision. You will have no input into how the company is run, no effective voting power, and no seat at the table during an acquisition. Our 409a valuation is just $100m!" As an employee, getting an option to pay for that is supposed to be an incentive?!

The solution I would like to see? Illiquid shares in a private startup less than 5 years old and with assets less than $100mm should be valued at a discount to liquidation value, or ideally transferable with no taxable event whatsoever. If those shares are encumbered or sold, then the holder pays short or long-term capital gain rates on the full amount of the sale. No 409a, no exercise price, no 83(b). There's absolutely no reason to try to pre-tax a portion of the value of the shares up-front when they are illiquid and impossible to value. This proposal is basically tax-neutral. If you want, you could extend the short-term capital gains rate to 2 or even 3 years instead of 1 for this type of transaction, to avoid someone taking highly valuable shares of a later-stage company, and getting the full amount taxed as capital gains just 12 months later.

To put this in perspective, with QSBS / Section 1202 (qualified small business stock) the first 10x or $10m of gains on original issue shares is 100% Federal capital gains free after a 5-year holding period. This was made permanent in 2015. Some states also eliminate or reduce the state capital gains as well -- although not California for a few years now :-( So politicians are making startup investing very attractive for anyone who can get Founder/Restricted or Preferred shares, but they have left the employees' options completely in the dark ages. It's time to fight for some reforms here...

> The solution I would like to see? Illiquid shares in a private startup less than 5 years old and with assets less than $100mm should be valued at a discount to liquidation value, or ideally transferable with no taxable event whatsoever.

I'm curious/confused about how/why RSUs don't satisfy what you want to see here? Is it just because they aren't actually transferrable or sellable given that the company is private?

>completely illiquid gain

Which is why "liquidity event" is one of the conditions for vesting.

I think that's an absolutely crazy way to try to avoid an 83(b) election. I would never want my stock locked up behind a dubious "liquidity event" requirement for vesting.

So you work for a startup for 10 years since inception, it's private all the time, you get annual grants for more and more options, building up options for 5% of the fully diluted shares, but then get disabled and have to stop working. Now you lose all your options because none of them have vested because the company didn't sell yet?

It's combined with a stipulation that you are still entitled to the shares whose "time-based condition" has been met, and will be granted them upon any liquidity event even after leaving the company.

Yeah, so Zynga did this... it's complicated and has many pitfalls. For example, their options expired after 7 years. There's also much debate around if the liquidity event can reasonably be construed as a legitimate "performance condition", and whether you have to start accounting for (and paying tax on) the otherwise vested shares once you can reasonable foresee a future liquidity event, not just after said liquidity event actually occurs.

https://www.sec.gov/Archives/edgar/data/1439404/000119312511...

It doesn't have to be solely a performance condition.

I don't think it would be hard to prevail on the facts arguing that a requirement for an IPO (or similar liquidity event) is wholly out of the employee's control and that a substantial risk of that not happening occurs up until the moment that it actually happens. IPOs fall apart/are withdrawn and mergers fail frequently enough that a substantial risk argument could probably be sustained.

Almost all your points apply exactly equally to restricted stock as it does to options. In both cases you will have a vesting schedule, just in the case of restricted stock it's usually a grant of the shares with no exercise price. In both cases you want to file an 83(b) election so you are taxed based on the FMV of the company when you receive the unvested shares (when the shares are worthless) so that you will only owe capital gains later.

But more importantly, in both cases you end up exactly and equally screwed in terms of you are holding the same class of stock (common) with the same vesting terms (no, single, or double trigger acceleration), all the exact same issues around dilution, liquidity, preferred shares, and unfair buyout terms funneling cash to key executives, etc.

Equity is a massive gamble all around, and there's no magic bullet that I've seen which can defray many of the inherent risks of owning common shares of a private company which has perhaps a 1 in 100 odds of ever seeing a public market or liquidity event that surpasses the total liquidation preferences.

> In both cases you will have a vesting schedule, just in the case of restricted stock it's usually a grant of the shares with no exercise price.

In practice, there are huge differences between them. Generally stock is much friendlier to employees and signals a company/founder which actually values employee ownership.

I'm surprised by the number of companies which try to pull shady stuff like not sharing the exercise price for options that are part of an offer. Lots of people apparently think that employees should value options at a substantially higher value than investors do. I've seen cases where the gap between the 409a price and the last investment is only a few thousand dollars, while the company insists this somehow makes up for a substantially subpar salary.

Equity is a risk, yes, but the status quo is that the risk falls much more on the people least able to bear it. Investors get all sorts of protections, while employees only benefit in a very narrow set of outcomes.

IIRC 83(b) on options is not available unless the company allows you to pre-exercise the options to turn them into shares prior to vesting.

So the vast majority of startup employees don't have the fancy tax-avoiding scheme that founders and investors have.

The only downside of early exercise I can see for the company is accounting for the cash and being ready to buy-back unvested shares as-needed. Since the tax implications are potentially massive for the employee, and we're talking de-minimis work for the employer, early exercise should be a standard term on all ISO contracts. I see this as an educational opportunity for Founders, and if you see a contract without early exercise I certainly wouldn't hesitate to question it.

Early exercise is great for the majority of situations. The 100k limit for ISO options can be a potential downside. If there is a spread between the strike price and the FMV, only the first 100k worth of shares will be considered ISOs and the rest will be treated as NSOs. In the case of no early exercise, you could get 100k of ISOs per year for the 4 years.

> So the vast majority of startup employees don't have the fancy tax-avoiding scheme that founders and investors have.

Investors never have vesting on their shares so 83(b) has nothing to do with the preferred stock investors receive. Founders of course do often have vesting and can benefit from filing an 83(b).

Sadly yes I think that is right

> In both cases you want to file an 83(b) election so you are taxed based on the FMV of the company when you receive the unvested shares

Can you do this, though? 83b election with ISOs makes sense because the tax event is employee writing a check to pre-exercise his shares, so a transaction occurs. For RSUs the transaction seems to occur at the time of the actual grant - there's no money changing hands, no transaction on record, and hence no tax event.

Not a tax lawyer, just trying to understand the complexity that I thought I had under control.

Great point! From http://www.investopedia.com/articles/tax/09/restricted-stock...

  Section 83(b) Election
  Shareholders of restricted stock are allowed to report the fair market value
  of their shares as ordinary income on the date that they are granted, instead
  of when they become vested, if they so desire. This election can greatly reduce
  the amount of taxes that are paid upon the plan, because the stock price at the
  time of grant is often much lower than at the time of vesting. Therefore, capital
  gains treatment begins at the time of grant and not at vesting. This type of election
  can be especially useful when longer periods of time exist between when shares are
  granted and when they vest (five years or more).

  Taxation of RSUs
  The taxation of RSUs is a bit simpler than for standard restricted stock plans.
  Because there is no actual stock issued at grant, no Section 83(b) election is
  permitted. This means that there is only one date in the life of the plan on which
  the value of the stock can be declared. The amount reported will equal the fair market
  value of the stock on the date of vesting, which is also the date of delivery in this
  case. Therefore, the value of the stock is reported as ordinary income in the year the
  stock becomes vested.

To me that means that Founders shares would be in the form of restricted stock, however RSUs would only be appropriate for liquid (publicly traded) shares.

Thanks for the clarification. Back to the grandparent's discussion, it seems that such election on RSUs is more punitive than on ISOs - an RSU grant to a high-income employee is then taxed as income, potentially as high as 39.6% at federal level (and whatever the state obligations are) versus AMT bill, which tops out at 28%.

That's correct.

However, I still much prefer RSUs over options in the case where you're joining a large/later stage company. Say you go to a Slack or Uber today. They won't (I believe they legally can't?) issue you options below their FMV (fair market value). They will give you some arbitrary/negotiable number of RSUs and options however. Then consider the following scenarios:

(1) The company then IPOs or is acquired several years from now, at double the current valuation. In this scenario, assuming you 83(b)'d and early exercised, you get the favorable tax treatment on the gains for the ISOs. But you're still out the exercise price outlay. The RSUs meanwhile are worth what they're worth, and you are taxed on them at the higher rate and that's that.

(2) The IPO or change of control happens too soon (less than 2 years from date of grant or 1 year from date of 83(b)/exercise). Your fancy options spread is still just ordinary income with no advantage over the RSUs.

(2) The company IPOs or is acquired next year, for the same FMV. Your options are worthless, your RSUs are still worth a goodly amount hopefully.

(3) The company IPOs at half the FMV of when you joined. Your options are worthless, your RSUs are worth something.

(4) The company fails/does a down round/whatever. You are probably wiped out regardless.

The only scenario in which the options are more interesting is as noted, very early stage companies where the exercise price is really small, or insane rocketships with an active secondary market providing real liquidity. Or, I guess when the company itself is holding liquidity events regularly (and even then it's only interesting if the FMV continues to grow up rapidly).

I've been making similar points too, it's actually shocking how founders and VCs are convinced that their way is the absolute correct way

Instead of pointing out how stock options are primarily a reaction to accounting and taxation changes over the years , or the conflicts of interest in giving a more objective answer

There are plenty of financial products possible that will tread the line of compensating employees for their risk and the lack of money and liquidity startups have

Well, if your goal is not to compensate employees, but to get all of the money, their way is the correct way.

Do you have any examples of these products?

I know of a german financial product, I keep forgetting the name of it, it is a hybrid of a stock and a bond, but it isn't what is typically considered a convertible note.

But basically it is granted at no cost to the employee, offers coupon payments, and matures at a point in time for the full cash value.

In the US, this would be OTC product limiting its utility much like every other kind of financial product that the government is 'protecting us' from. But it wouldn't be impossible to offer to employees.

For startups, the coupon payments would be relatively small, and refresher grants can still be done. If the startup goes bust, it goes bust. Provisions to make it callable can be implemented so in a bigger liquidity event valuing the company higher, employees can still get a lot of liquidity early, and it would likely be senior to common stock.

Anyway, I'll try to get the name of it. It was a lot more counterintuitive than hybrid bond.

edit: genussscheine , or participation certificate. Exempt from securities regulation in germany, but would be OTC in US.

Having been involved in a startup which offered participation certificates, I'll say this: Stay far, far away. Nope, even further than that.

Participation certificates are derivatives of an underlying, either a separate share class, or even worse, options on a separate share class. Startup equity is hard enough to value outright. Derivatives on customized terms in a market which is by definition highly illiquid? No thanks.

(It doesn't help when the terms of both shareholder agreement and participation certificate agreement are slanted in favour of the early employees/founders by so much that the participation certificates are worthless on close inspection, but that's a different rant.)

yeah, cash money.

if a startup has VC's and lawyers sitting around dreaming up and codifying a complicated and rather arbitrary set of rules to protect their investment from the little people, there's enough cash floating around to pay the employees a fair salary, they just don't want to.

options are fool's gold, plain and simple. you are either a founder, or a venture capitalist, or lawyer, or you should expect a zero or negative value from this silly charade.

if you can't tell which person sitting at the poker table is the sucker...

>>> There are plenty of financial products possible that will tread the line of compensating employees for their risk and the lack of money and liquidity startups have

>> Do you have any examples of these products?

> yeah, cash money.

Sorry, I don't follow. The standard term sheets available today can reduce the cost of issuing options or RSUs to a few thousand dollars. It's actually a very straightforward and simple process to get stared, and has to be done anyway to at least get shares into the Founder's hands on Day 1. So, yes, there are startup legal expenses, but you are paying it no matter what, adding an option pool up front does not really cost any extra.

Are there any companies you know that use RSU's or stock grants instead of options? I've been interviewing at some startups and they only seem to offer options with their byzantine rules. Can people negotiate offers from options to RSUs/grants?

RSUs are typical at a certain size -- generally around 500 employees I think these days. There's a forcing function called the Exchange Act, section 12(g) of which says there's a cap on the number of shareholders you can have without reporting financials effectively as if you're a public company. That number was increased from 500 shareholders to 2000 in 2012. The reason for the lower number where RSUs start to be considered than where strictly required has a couple motivations:

1) Generally by 200 employees your stock is starting to be expensive, so exercising is no longer a trivial amount of money. This is especially important if an employee wants to 83(b) exercise (which is pre-buying their shares as soon as they're granted, to move the long term capital gains clock up to a year ahead of where it would otherwise kick in).

2) Getting to 500 employees generally implies some attrition, and of course your investors are also on your cap table, so it's fairly easy to be approaching 2000 shareholders with a smaller number of employees depending on how fast you've grown and how many party rounds you've done.

3) RSUs are trivial for the company to control. Shares that you own can, without special restrictions which are only starting to become standard in the last few years, can be traded on secondary markets even if you can't trade them on a public exchange. RSUs are simply a promise, and while you could write a contract that dictates what you'll do at the time of RSU conversion, that doesn't affect the company because by definition they're already public by then.

Selling your vested options to another party is much harder on the company, since as shareholders this third party has an explicit relationship with the company and, depending on where they are incorporated, rights to examine the company's finances.

Oh, and rereading I just realized I didn't connect the dots from the 12(g) threshold forcing people to use RSUs. RSUs are not considered stock. For tax purposes they are ordinary compensation awarded at the time of conversion, and only then do you count as a shareholder in the company. A company like Uber (could easily have been over 2000 shareholders by now I'm sure) has been using RSUs for probably multiple years now.

Thanks for this. This is a good analysis of how RSUs are advantageous to both employees and employers.

You need to pay taxes on your stock. With options you only pay when you exercise so you can wait until liquidity to make sure you can afford the taxes. If you are getting straight stock you need to pay taxes that year

But if you're getting straight stock, odds are the price is so low to where it shouldn't be much. At least, nowhere near the tax bill one would get if they tried to exercise options in a company that's taken off (but not gone public yet).

If you're joining a company very early (first 10 employees) you should probably be getting stock (not options). It's possible to do that and is a sign of an employee-friendly founder. Plus, at an early stage you can do an 83(b) on the stock itself and have a much more favorable tax situation.

I have successfully negotiated for founder stock instead of options in the past, so it's something you can definitely do.

What if the earliest employees make no sacrifice and take no risk?