Our Equity 101 education series focused on stock options and how they work. In this post, we explain the two most common alternatives to stock options: RSAs and RSUs. By the end of this post you will have a general of understanding of how they work, the key differences between them, and, if you're a founder, how to choose between the two when incentivizing startup employees.
This post is broken into four sections:
1) What is restricted stock?
2) Vesting and RSUs and RSAs
3) How termination affects RSUs and RSAs
4) Taxes and restricted stock
What is restricted stock?
Restricted stock is very different from a stock option. A stock option gives you the right to buy a set number of shares at a fixed price, but you don't own the shares until you buy them. With restricted stock, you own the shares from the day they are issued.
But the stock is “restricted” stock because you still need to earn them. The most common restrictions are time-based and involve a vesting schedule, which means you earn them over time. This incentivizes employees to stay longer with the company who issued them while protecting the company by allowing the company to repurchase the stock if the employee leaves.
There are two main types of restricted stock: Restricted Stock Awards (RSAs) and Restricted Stock Units (RSUs).
What is an RSA?
We’ll be using Sean as an example of an RSA recipient. Sean is one of the first five employees at a startup. Because the startup doesn't have a lot of cash to pay for salaries, they offer Sean an RSA as part of his offer.
RSA shares are given to employees on the day they are granted. RSAs are typically issued to early employees before the first round of equity financing when the FMV of the Common stock is very low. RSAs provide the individual the right to purchase shares at FMV, at a discount, or at no cost on the grant date.
The employee "owns" the stock associated with the RSA on the grant date, but may still have to purchase them, depending on the nature of the offer. This purchase contingency is why RSAs are considered "restricted".
What is an RSU?
Gus is our second example employee, and he joins the same company seven years later. The company is now successful and the share price has increased dramatically. In addition to a fair salary, the company gives Gus Restricted Stock Units (RSUs) as part of his offer.
An RSU is Common stock to be delivered at a future date, contingent on vesting and performance conditions. Shares are not received until the restrictions lapse. RSUs incentivize employees to stay with a company and help it perform so shares increase in value.
Unlike RSAs, when shares are "owned" by the employee on the grant date, an RSU is a promise from the company to give an employee shares at a later date.
The date you actually receive your RSU shares can be a vesting date, a liquidation event, a specified date in the future, or some combination of these. This future date is established when the RSU is granted. Another key difference from an RSA is that the RSU holder does not pay anything to own the shares (outside of applicable taxes).
Vesting and RSUs and RSAs
Vesting means you have to earn your shares over time.
Because you legally own RSA shares when they are granted to you, vesting only impacts whether the company can repurchase your shares if you leave or are terminated. Most companies have vesting schedules in place to prevent individuals from joining a company, receiving their RSA award, and leaving immediately.
RSU shares are not issued to the recipient until they vest. When a company grants RSUs, they are promising to issue those shares at a later date based on the vesting schedule.
RSUs can have multiple vesting conditions. In our example, Gus’s RSU has a time-based vesting schedule AND a liquidation condition. The liquidation condition states that "the company must be acquired or IPO before Gus’s shares will vest." Gus has to satisfy his time-based vesting schedule AND the liquidation condition before his shares will be issued.
How termination affects RSUs and RSAs
We’ll use Sean (RSA) and Gus (RSU) to explain how termination differs between RSAs and RSUs.
The chart above shows what happens to Sean and Gus’s shares if they leave the company - in this example, both Sean and Gus are partially vested upon termination.
Termination and RSAs
Sean keeps all of his vested shares. His unvested shares, however, are subject to a company repurchase. That means the company can buy the shares back from Sean. Companies will usually repurchase shares at the same price Sean paid for them. It is important to note that the company has the right, but not the obligation, to repurchase the shares from the employee.
Termination and RSUs
Gus also keeps his vested shares, but there is one caveat: because RSUs are often subject to additional vesting conditions (like a liquidation event), it is possible that Gus’s time-vested shares will expire before both conditions are met. If Gus’s shares expire before the company gets acquired or IPOs, he will not get to keep the time-vested shares. Regardless of liquidation conditions, any shares that are not time-vested are forfeited at termination. (Some companies will allow ex-employees to keep RSUs which have met the time-based vesting requirement but not the event-based vesting requirement. It is important to read the grant agreement to understand what will happen to your RSUs in the event you leave the company.)
Taxes and restricted stock
There are two types of tax to consider with equity compensation: ordinary income tax and capital gains tax. The main thing to remember is that the capital gains tax rate is generally lower than the ordinary income tax rate.
The tax treatment of RSAs and RSUs is complicated and confusing - knowing how taxation works with these forms of equity compensation can potentially help startup employees save thousands of dollars.
Remember, any time your company pays you — whether in salary, benefits, or equity — the government will make you pay taxes.
RSAs and Taxes
When Sean was granted an RSA by his company, he had to pay for his RSA shares to own them outright. Because Sean paid for them, the company is not giving him any additional value. This means he doesn’t have to pay taxes on his RSA on the grant date.
Eventually those shares may increase in value. If they do, Sean will have to pay taxes on the gain. It's easier to see and understand the tax treatment in a graph:
The graph shows Sean’s taxable gain over time. On the x-axis is the Fair Market Value (FMV) of Sean’s shares. The y-axis (Taxable Gain) is just the current FMV minus the FMV on the grant date ($1). When Sean’s shares vest, the FMV is $5, yielding a taxable gain of $4 ($5-$1).
Any taxable gain between the grant date and vesting is subject to ordinary income tax. Once the shares vest, Sean owns them. At this point, any subsequent gain between vesting and Sean selling his shares is subject to capital gains tax.
The key takeaway here is that you’re paying tax when shares vest. At this point, however, the shares may be illiquid (which means you can't sell them). The yellow line in the graph could just as well plummet after vesting, and the shares would be worthless. If you’ve already paid tax, the IRS will not refund your payment.
Thankfully, there’s a solution for this. Enter the section 83(b) election!
Section 83(b) election
The 83(b) election means that you can choose to pay all of your ordinary income tax up front. A valid question now would be, “why would I want to pay taxes early?”
As you’ll see in the next graph, the taxable gain is usually zero (or close to zero) when you make an 83(b) election. Because you haven’t "gained" anything yet you don’t have to pay ordinary income tax on your RSA holdings. It’s important to note that there is a 30-day deadline from grant to file an 83(b) election. After this window passes Sean will not be able to file the election.
Sean’s taxable gain is zero at grant because the FMV is the same as what he paid ($1). By filing an 83(b) election, Sean is choosing to recognize ordinary income tax up front. Since the taxable gain is $0, Sean pays no ordinary income tax.
Even when the shares vest, Sean pays no tax. Instead, he pays a capital gains tax on the full $9 gain when he sells the shares. This is favorable for two reasons:
1) the capital gains tax is a lower rate than ordinary income
2) he does not run the risk of paying taxes on illiquid shares that cannot be sold
RSUs and Taxes
The main thing to know about RSUs and taxes is that you pay ordinary income tax when your shares vest. This is similar to how RSAs are taxed if you don’t make the Section 83(b) election.
The following graph is the same as the RSA graph from above without the section 83(b) election.
Gus was granted an RSU when the FMV of the RSU was $1. Since he doesn’t receive any shares when the RSU is granted, he is not responsible for paying taxes on that $1. The taxable gain is $0 on the grant date.
Instead, Gus will pay ordinary income tax on the full FMV when his RSUs vest at the FMV of $5. But why is Gus responsible for taxes on the full $5 when Sean only paid taxes on the $4 gain for his RSA? It's because Sean paid the $1 to purchase his shares when he was granted his RSA.
Like the gain on Sean’s RSA, Gus will pay capital gains tax on the difference between the $5 FMV at vesting and the $10 FMV when he sells.
Remember that RSUs often have multiple vesting conditions; in the example above, we assume Gus's RSU only has time-based vesting. Now, let's look at how a liquidation condition affects his RSU taxes:
Gus will be taxed when the time-based vesting AND liquidation requirements are satisfied. He will pay ordinary income tax on the entire value of his RSU ($10) at the liquidation event because he sells the RSU shares at the same time they vest.
Recap: RSAs vs. RSUs
The chart above outlines the key differences between RSAs and RSUs. To recap:
Purchasing restricted stock: RSAs are paid for on the grant date. RSUs are not paid for.
Vesting: RSAs usually have time-based vesting conditions. RSUs often have multiple vesting conditions until the employee owns the shares outright.
Termination: Unvested RSA shares are subject to repurchase upon termination. Unvested RSU shares are forfeited back to the company immediately.
Taxes: RSAs are eligible for 83(b) elections. RSUs are not eligible for 83(b) elections and are taxed when they vest.
Timing is key with RSAs and RSUs - when they vest, when you sell, and when you can expect to receive them are important factors in determining the full value of these equity compensation awards.
RSAs are generally issued in the very early stages of a company when the FMV of Common stock is very low and salary requirements are difficult to meet. RSAs let early employees fully participate in the upside of company growth. When a company enters its growth phase, it usually makes sense to use options for the majority of a company's equity compensation plans. Once a company is mature and successful, the FMV is often too expensive for most employees to afford. RSUs then become a more viable incentivization tool.
Restricted stock can be confusing and the information is a lot to take in. The complexity increases when you're distributing restricted stock to employees and it starts impacting your cap table and ownership structure. To learn more about how Carta can help, schedule a demo of our platform with one of our equity experts.