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Are there different types of equity compensation?
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How Equity is Granted32 minutes, 35 links

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.

🚧incomplete Add section on when equity is granted, including plus-ups.

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.”

☝️confusion Restricted stock awards are not the same thing as restricted stock units.

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.

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.

🚧incomplete Any real-world examples or statistics of how low strike price has led to big payoffs?

🚧incomplete Mention and relate this to the term employee stock options (or ESOs)? Dispel any confusion between ESOs and ESPPs?

Vesting and cliffs

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.

Awards of stock, stock options, and RSUs are almost always subject to a vesting schedule.

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:

  • The intention of a cliff is to make sure new hires are committed to staying with the company for a significant period of time. However, the flip side of vesting with cliffs is that if an employee is leaving—quits or is laid off or fired—just short of their cliff, they may walk away with no stock ownership at all, sometimes through no fault of their own, as in the event of a family emergency or illness. In situations where companies fire or lay off employees just before a cliff, it can easily lead to hard feelings and even lawsuits (especially if the company is doing well enough that the stock is worth a lot of money).
  • 🔹important As a manager or founder, if an employee is performing poorly or may have to be laid off, it’s both thoughtful and wise to let them know what’s going on well before their cliff.
  • technical Founders often have vesting on their stock themselves. As entrepreneur Dan Shapiro explains, this is often for good reason.
  • 🔹important As an employee, if you’re leaving or considering leaving a company before your vesting cliff is met, consider waiting. Or, if your value to the company is high enough, you might negotiate to get some of your stock “vested up” early. Your manager may well agree that is is fair for someone who has added a lot of value to the company to own stock even if they leave earlier than expected, especially for something like a family emergency. These kinds of vesting accelerations are entirely discretionary, however, unless you negotiated for special acceleration in an employment agreement. Such special acceleration rights are typically reserved for executives who negotiate their employment offers heavily.
  • 🚧incomplete How does taking time off, for example a leave of absence, affect the vesting schedule?
  • Acceleration when a company is sold (called change of control terms) is common for founders and not so common for employees. It’s worth understanding acceleration and triggers in case they show up in your option agreement, but these may not be something you can negotiate unless you are going to be in a key role.
  • Companies may impose additional restrictions on stock that is vested. For example, your shares are very likely subject to a right of first refusal, which means that you can’t sell the stock without offering it first to the company. And it can happen that companies reserve the right to repurchase vested shares in certain events.

🚧incomplete Can we give any examples here?

How options expire

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:

  • Everyone agrees that employees holding stock options with an expiring window often have to make a painful choice if they wish to leave: Pay for a substantial tax bill (perhaps five to seven figures) on top of the cost to exercise (possibly looking for secondary liquidity or a loan) or walk away from the options.
  • Many familiar with this situation have spoken out forcefully against shorter exercise windows, arguing that an employee can help grow the value of a company substantially—often having taken a lower salary in exchange for equity—but end up with no ownership because they’re unable or unwilling to stay for the several years typically needed before an IPO or sale.
  • On the other side, a few companies and investors stand by the existing system, arguing that it is better to incentivize people not to leave a company, or that long windows effectively transfer wealth from employees who commit long-term to those who leave.
  • Some focused on the legalities also argue that it’s a legal requirement of ISOs to have a 90-day exercise window. While this is technically true, it’s not the whole story. It is possible for companies to extend the exercise window by changing the nature of the options (converting them from ISOs to NSOs) and many companies now choose to do just that.
  • Another path is to split the difference and give extended windows only to longer-term employees.
  • Taken together, it’s evident many employees have not been clear on the nuances of this when joining companies, and some have suffered because of it. With the risks of short exercise windows for employees becoming more widely known, longer exercise windows are gradually becoming more prevalent. As an employee or a founder, it is fairer and wiser to understand and negotiate these things up front, and avoid unfortunate surprises.

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 📥documentFounder/Advisor Standard Template (FAST), from the Founder Institute.

Kinds of stock options

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.

TypeAlso called
StatutoryIncentive stock option, ISO
Non-statutoryNon-qualifying stock option, NQO, NQSO, NSO
  • Companies generally decide to give ISOs or NSOs depending on the legal advice they get. It’s rarely up to the employee which they will receive, so it’s best to know about both. There are pros and cons of each from both the recipient’s and the company’s perspective.
  • ISOs are common for employees because they have the possibility of being more favorable from a tax point of view than NSOs.
  • 🔸caution ISOs can only be granted to employees (not independent contractors or directors who are not also employees).
  • But ISOs have a number of limitations and conditions and can also create difficult tax consequences.

Early exercise

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.

Restricted stock units

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.

  • 🔸caution RSUs may vest according to a vesting schedule. The settlement date may be the time-based vesting date or a later date based on, for instance, the date of a company’s IPO.
  • RSUs are difficult in a startup or early stage company because when the RSUs vest, the value of the shares might be significant, and taxes will be owed on the receipt of the shares. This is not a bad result when the company has sufficient capital to help the employee make the tax payments, or the company is a public company that has put in place a program for selling shares to pay the taxes. But for cash-strapped private startups, neither of these are possibilities. This is the reason most startups use stock options rather than RSUs or stock awards.
  • RSUs are often considered less preferable to grantees since they remove control over when you owe tax. Options, if granted with an exercise price equal to the fair market value of the stock, are not taxed until exercise, an event under the control of the optionee. If an employee is awarded an RSU or restricted stock award which vests over time, they will be taxed on the vesting schedule; they have been put on “autopilot” with respect to the timing of the tax event. If the shares are worth a lot on the date of vesting, the tax burden can be significant.
  • ☝️confusion You don’t want to confuse restricted stock units with restricted stock, which typically refers to restricted stock awards.

Less common types of equity

While most employee equity compensation takes the form of stock, stock options, or RSUs, a complete tour of equity compensation must mention a few less common forms.

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.

🚧incomplete Elaboration needed on what events typically trigger phantom stock. More data on how rare these are? And what is appreciation?

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.

You’re reading an excerpt from a Holloway Guide.
The Holloway Guide to Equity Compensation
Joshua Levy, Joe Wallin, and over 35 contributors
Over 3 hours and 300 linked resources

Stock options, RSUs, job offers, and taxes—a detailed reference, including hundreds of resources, explained from the ground up and made to be improved over time.