Our first education series (Equity 101) focused on stock options and how they work. In this post, we break down 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 when to use which.
We'll cover 4 topics in this post: restricted stock, vesting, termination, and taxes.
Let's start with restricted stock.
The first thing to know is that having restricted stock is different from having stock options. Stock options give 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.
It’s called “restricted” stock because even though you own the shares you have to earn them. The most common restriction is time-based vesting, which means you earn them over time. This incentivizes employees to stay at the company longer.
We'll cover 2 types of restricted stock: Restricted Stock Awards (RSAs) and Restricted Stock Units (RSUs). Let’s start with RSAs.
We’ll be using Sean as our example. Sean is one of the first 5 employees at a startup, and he gets an RSA as part of his offer.
The biggest difference between RSAs and RSUs is that RSA shares are given to you on the day they are granted. When Sean gets his RSA he legally owns the shares, which means he needs to pay for them.
There are a few prices Sean can pay for the shares. The most common price is called “par value.” Because the company is so young, the price of the shares is still low — typically a fraction of cent.
Gus is our second example employee, and he joins the same company 7 years later. At this point, the company has done very well and the share price has increased dramatically. Gus gets Restricted Stock Units (RSUs) as part of his offer.
There are a couple differences between RSUs and RSAs:
The first is that you do not own RSU shares on the day they are granted (like with RSAs). Instead, Gus's RSU is a promise from the company to give him shares at a later date. Additionally, Gus does not have to pay for the RSU shares.
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. The main point is that it is a future date established when the RSU is granted.
Alright, now let’s talk about how RSAs and RSUs vest.
Let's start with RSAs.
To recap from Equity 101, vesting means you have to earn your shares over time.
Because you legally own RSA shares when they are granted to you, vesting only controls whether the company can buy back your shares if you leave. When a company buys back your shares, this is called a repurchase.
RSU vesting is slightly different. The main distinction is that RSU shares are not issued until they vest. When a company grants you RSUs, they are promising to issue those shares at a later date (based on the vesting schedule).
RSUs often have multiple vesting conditions. For example, Gus’s RSU has a time-based vesting schedule AND a liquidation condition. The liquidation condition says, "the company must get 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.
Ok, let’s talk about termination.
We’ll look at two examples to show how termination differs with 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 at the time they leave. Let’s start with Sean’s RSA.
As you can see in the chart Sean keeps his vested shares. His unvested shares, however, are subject to “repurchase” by the company. That means the company can buy the shares back from Sean. Companies will usually repurchase shares at the same price Sean paid for them.
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.
Alright, let’s get into taxes.
There are two types of tax to think about: Ordinary Income tax and Capital Gains tax. The main thing to remember is that Capital Gains tax is generally better than Ordinary Income tax because it’s a lower rate.
Remember, any time your company pays you — whether in salary, benefits, or equity — the government will make you pay taxes. In the cases of RSAs and RSUs, your company is paying you in the form of equity. Let’s see how both are taxed.
We’ll start with RSA taxes. Sean was granted an RSA by his company. As we discussed, Sean has to pay for his RSA shares when he gets them. Because Sean pays for the shares, the company is not giving him any additional value. This means he doesn’t have to pay tax at that time.
Eventually, those shares might gain value. If they do Sean will have to pay taxes on the gain. Let’s see what that looks like in a graph.
This graph shows Sean’s taxable gain over time. On the x-axis, we have the Fair Market Value (FMV) of Sean’s shares. The y-axis (Taxable Gain) is just the current FMV minus the FMV at grant ($1). For example, when Sean’s shares vest, the current FMV is $5. That means his taxable gain is $4 ($5-$1).
Any taxable gain between grant and vest is treated as Ordinary Income tax. Once the shares vest, Sean owns them. At this point, any gain between vest and sale is treated as Capital Gains tax.
The key takeaway here is that you’re paying tax at vest but the shares are still illiquid (which means you can't sell them). The yellow line could just as well plummet after vest, 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!
This election means that you can choose to pay all of your Ordinary Income tax up front. You might be wondering, “why would I want to pay tax 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 any gains.
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.
As you’ll notice, even when the shares vest, Sean pays no tax. Instead, he pays Capital Gains tax on the full $9 gain when he sells the shares later on. This is favorable for two reasons: 1) Capital Gains is a lower rate, and 2) he does not run the risk of paying tax on illiquid shares that cannot be sold.
Ok, so now let’s look at RSU taxes.
The main thing to know about RSUs is that you pay Ordinary Income tax when your shares vest. This is similar to how RSAs are taxed if you don’t make a Section 83(b) election.
Let’s take a look at this in a graph.
Gus was granted an RSU when the FMV was $1. Since he doesn’t receive any shares when he gets the RSU he is not responsible for paying taxes on that $1, making the taxable gain $0 at grant.
Instead, Gus will pay Ordinary Income tax on the full FMV when his RSUs vest ($5). You might be wondering why Gus paid tax on the full $5 when Sean only paid tax on the $4 gain. The reason is that Sean already paid the $1 when he was granted his RSA.
Like Sean’s RSA, Gus will pay Capital Gains tax on the difference between the $5 vest FMV and $10 sale FMV ($10-$5).
As we mentioned earlier, however, RSUs often have multiple vesting conditions. In the example above, we assume Gus's RSU only has time-based vesting. Now let's see how a liquidation condition affects his tax.
Gus will be taxed only 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.
Let’s do a quick recap.
The chart above outlines the differences between RSAs and RSUs. Here are the key points we've covered:
Restricted stock: RSAs are paid for at grant. RSUs are not paid for at grant.
Vesting: RSAs usually have time-based vesting. RSUs often have multiple vesting conditions.
Termination: Unvested RSA shares are subject to repurchase. Unvested RSU shares are forfeited immediately.
Tax: RSAs are eligible for 83(b) elections. RSUs are not eligible for 83(b) elections and are taxed at vest.
The main takeaway from RSAs and RSUs is that timing matters. RSAs are generally only issued in the very early stages of a company (i.e. the first five employees) when the FMV is very low. After that point, it usually makes sense to use options for the majority of a company's growth phase. This lets employees participate in the upside. Only at the later stages, when the FMV is too expensive for most employees to afford, will companies start issuing RSUs.