In this section we’ll lay out how equity is granted in practice, including the differences, benefits, and drawbacks of common types of equity compensation, including restricted stock awards, stock options, and restricted stock units (RSUs). We’ll go over a few less common types as well. While the intent of each kind of equity grant is similar, they differ in many ways, particularly around how they are taxed.
Except in rare cases where it may be negotiable, the type of equity you get is up to the company you work for. In general, larger companies grant RSUs, and startups grant stock options, and occasionally executives and very early employees get restricted stock awards.
At face value, the most direct approach to equity compensation would be for the company to award stock to an employee in exchange for work. In practice, it turns out a company will only want to do this with restrictions on how and when the stock is fully owned.
Even so, this is actually one of the least common ways to get equity. We mention it first because it is the simplest form of equity compensation, useful for comparison as things get more complex.
Definition A restricted stock award is when a company grants someone stock as a form of compensation. The stock awarded has additional conditions on it, including a vesting schedule, so is called restricted stock. Restricted stock awards may also be called simply stock awards or stock grants.
technical What restricted means here is actually complex. It refers to the fact that the stock (i) has certain restrictions on it (like transfer restrictions) required for private company stock, and (ii) will be subject to repurchase at cost pursuant to a vesting schedule. The repurchase right lapses over the service-based vesting period, which is what is meant in this case by the stock “vesting.”
Typically, stock awards are limited to executives or very early hires, since once the value of the shares increases, the tax burden of receiving them (without paying the company for their value) can be too great for most people. Usually, instead of restricted stock, an employee will get stock options.
Definition Stock options are contracts that allow individuals to buy a specified number of shares in the company they work for at a fixed price. Stock options are the most common way early-stage companies grant equity.
Definition A person who has received a stock option grant is not a shareholder until they exercise their option, which means purchasing some or all of their shares at the strike price. Prior to exercising, an option holder does not have voting rights.
Definition The strike price (or exercise price) is the fixed price per share at which stock can be purchased, as set in a stock option agreement. The strike price is generally set lower (often much lower) than what people expect will be the future value of the stock, which means selling the stock down the road could be profitable.
confusion Stock options is a confusing term. In investment, an option is a right (but not an obligation) to buy something at a certain price within a certain time frame. You’ll often see stock options discussed in the context of investment. What investors in financial markets call stock options are indeed options on stock, but they are not compensatory stock options awarded for services. In this Guide, and most likely in any conversation you have with an employer, anyone who says “stock options” will be referring to compensatory stock options.
confusion Stock options are not the same as stock; they are only the right to buy stock at a certain price and under a set of conditions specified in an employee’s stock option agreement. We’ll get into these conditions next.
technical Although everyone typically refers to “stock options” in the plural, when you receive a stock option grant, you are receiving an option to purchase a given number of shares. So technically, it’s incorrect to say someone “has 10,000 stock options.”
It’s best to understand the financial and tax implications before deciding when to exercise options. In order for the option to be tax-free to receive, the strike price must be the fair market value of the stock on the date the option is granted.
technical Those familiar with stock trading (or those with economics degrees) will tell you about the Black-Scholes model, a general mathematical model for determining the value of options. While theoretically sound, this does not have as much practical application in the context of employee stock options.
Definition Vesting is the process of gaining full legal rights to something. In the context of compensation, founders, executives, and employees typically gain rights to their grant of equity incrementally over time, subject to restrictions. People may refer to their shares or stock options vesting, or may say that a person is vesting or has fully vested.
Definition In the majority of cases, vesting occurs incrementally over time, according to a vesting schedule. A person vests only while they work for the company. If the person quits or is terminated immediately, they get no equity, and if they stay for years, they’ll get most or all of it.
Definition Vesting schedules can have a cliff designating a length of time that a person must work before they vest at all.
For example, if your equity award had a one-year cliff and you only worked for the company for 11 months, you would not get anything, since you haven’t vested in any part of your award. Similarly, if the company is sold within a year of your arrival, depending on what your paperwork says, you may receive nothing on the sale of the company.
A very common vesting schedule is vesting over 4 years, with a 1 year cliff. This means you get 0% vesting for the first 12 months, 25% vesting at the 12th month, and 1/48th (2.08%) more vesting each month until the 48th month. If you leave just before a year is up, you get nothing, but if you leave after 3 years, you get 75%.
Definition In some cases, vesting may be triggered by specific events outside of the vesting schedule, according to contractual terms called accelerated vesting (or acceleration). Two kinds of accelerated vesting that are commonly negotiated are if the company is sold or undergoes a merger (single trigger) or if it’s sold and the person is fired (double trigger).
controversy Cliffs are an important topic. When they work well, cliffs are an effective and reasonably fair system to both employees and companies. But they can be abused and their complexity can lead to misunderstandings:
Definition The exercise window (or exercise period) is the period during which a person can buy shares at the strike price. Options are only exercisable for a fixed period of time, until they expire, typically seven to ten years as long as the person is working for the company. But this window is not always open.
danger Expiration after termination: Options can expire after you quit working for the company. Often, the expiration is 90 days after termination of service, making the options effectively worthless if you cannot exercise before that point. As we’ll get into later, you need to understand the costs, taxes, and tax liabilities of exercise and to plan ahead. In fact, you can find out when you are granted the options, or better yet, before you sign an offer letter.
important Longer exercise windows: Recently (since around 2015) a few companies are finding ways to keep the exercise window open for years after leaving a company, promoting this practice as fairer to employees. Companies with extended exercise windows include Amplitude, Clef, Coinbase, Pinterest, and Quora. However, the 90-day exercise window remains the norm.
controversy The exercise window debate: Whether to have extended exercise windows has been debated at significant length. Some believe extended exercise windows are the future, arguing that a shorter window makes a company’s success a punishment to early employees.
Key considerations include:
A note on advisors: Options granted to advisors typically vest over a shorter period than employee grants, often one to two years. Advisor grants also typically have a longer exercise window post termination of service, and will usually have single trigger acceleration on an acquisition, because no one expects advisors to stay on with a company once it’s acquired. Typical terms for advisors, including equity levels, are available in the Founder/Advisor Standard Template (FAST), from the Founder Institute.
Definition Compensatory stock options come in two flavors, incentive stock options (ISOs) and non-qualifying stock options (NQOs, or NQSOs). Confusingly, lawyers and the IRS use several names for these two kinds of stock options, including statutory stock options and non-statutory stock options (or NSOs), respectively.
In this Guide, we refer to ISOs and NSOs.
|Statutory||Incentive stock option, ISO|
|Non-statutory||Non-qualifying stock option, NQO, NQSO, NSO|
Definition Sometimes, to help reduce the tax burden on stock options, a company will make it possible for option holders to early exercise (or forward exercise) their options, which means they can exercise even before they vest. The option holder becomes a stockholder sooner, after which the vesting applies to actual stock rather than options. This will have tax implications.
caution However, the company has the right to repurchase the unvested shares, at the price paid or at the fair market value of the shares (whichever is lower), if a person quits working for the company. The company will typically repurchase the unvested shares should the person leave the company before the stock they’ve purchased vests.
While stock options are the most common form of equity compensation in smaller private companies, RSUs have become the most common type of equity award for public and large private companies. Facebook pioneered the use of RSUs as a private company to allow it to avoid having to register as a public company earlier.
Definition Restricted stock units (RSUs) refer to an agreement by a company to issue an employee shares of stock or the cash value of shares of stock on a future date. Each unit represents one share of stock or the cash value of one share of stock that the employee will receive in the future. (They’re called units since they are neither stock nor stock options, but another thing altogether that is contractually linked to the value of stock.)
Definition The date on which an employee receives the shares or cash payment for RSUs is known as the settlement date.
Definition Phantom equity is a type of compensation award that references equity, but does not entitle the recipient to actual ownership in a company. These awards come under a variety of different monikers, but the key to understanding them is knowing that they are really just cash bonus plans, where the cash amounts are determined by reference to a company’s stock. Phantom equity can have significant value, but may be perceived as less valuable by workers because of the contractual nature of the promises. Phantom equity plans can be set up as purely discretionary bonus plans, which is less attractive than owning a piece of something.
Two examples of phantom equity are phantom stock and stock appreciation rights:
Definition A phantom stock award is a type of phantom equity that entitles the recipient to a payment equal to the value of a share of the company’s stock, upon the occurrence of certain events.
Definition Stock appreciation rights (SARs) are a type of phantom equity that gives the recipient the right to receive a payment calculated by reference to the appreciation in the equity of the company.
Definition Warrants are another kind of option to purchase stock, generally used in investment transactions (for example, in a convertible note offering, investors may also get a warrant, or a law firm may ask for one in exchange for vendor financing). They differ from stock options in that they are more abbreviated and stand-alone legal documents, not granted pursuant to a single legal agreement (typically called a “plan”) for all employees.
Employees and advisors may not encounter warrants, but it’s worth knowing they exist.