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Equity compensation is a powerful tool to attract and retain talent, but choosing the right type depends on your company’s stage and goals. Here’s a quick breakdown of the three main types:
- NSOs (Non-Qualified Stock Options): Flexible and available for employees, contractors, and partners. Taxed as ordinary income at exercise.
- ISOs (Incentive Stock Options): For U.S. employees only, offering potential tax perks if holding requirements are met. No tax at exercise, but may trigger AMT.
- RSUs (Restricted Stock Units): Shares are granted outright at vesting, making them simple and predictable but taxed as income at vesting.
Quick Comparison
| Type | Best For | Key Features | Tax Timing | Tax Rate |
|---|---|---|---|---|
| NSOs | Early-stage companies | Flexible, usable for non-employees | At exercise | Ordinary income |
| ISOs | Employees in startups | Tax advantages, capital gains option | At sale (if held)* | Capital gains |
| RSUs | Growth-stage companies | Simple, no exercise required | At vesting | Ordinary income |
Key Insights:
- Early-stage startups often use NSOs or ISOs to conserve cash and offer upside potential.
- Growth-stage or mature companies prefer RSUs for simplicity and retention.
- Tax and legal compliance are critical - consult experts to avoid costly mistakes.
This guide dives into the pros, cons, tax details, and legal requirements of each type, so you can align your equity strategy with your company’s goals.
Stock Options vs RSUs: Two Types Of Company Equity
Types of Equity Compensation
Equity compensation comes in different forms, each tailored to serve specific purposes and needs. Here's a closer look at the main types and how they work.
NSOs (Non-Qualified Stock Options)
NSOs are versatile because they can be granted to employees, independent contractors, and even vendors. They give the holder the right to buy company shares at a set price within a certain time period. Typically, NSOs vest over four years at 25% annually. When exercised (for example, buying shares at $10 when the market value is $25), the $15 difference is taxed as ordinary income. Compared to ISOs, NSOs are less restrictive, making them a more flexible option for companies.
ISOs (Incentive Stock Options)
ISOs are designed exclusively for employees and follow strict IRS rules. They can provide tax advantages - employees may pay capital gains tax instead of the higher ordinary income tax on the difference between the exercise price and market value, as long as certain holding requirements are met. However, ISOs have limits, such as a $100,000 cap on the total grant value that can become exercisable in a calendar year.
RSUs (Restricted Stock Units)
RSUs take a simpler approach to equity compensation. Unlike NSOs and ISOs, RSUs don’t require employees to buy shares - they receive them outright once they vest. This makes RSUs particularly appealing for more established companies or mature startups, as they retain value even if the stock price drops. Employees get the shares immediately at vesting, avoiding the need for purchase decisions.
The best option depends on factors like the company’s stage, employee preferences, and overall goals. Early-stage startups often lean toward NSOs or ISOs to conserve cash while offering potential for significant gains. In contrast, mature companies tend to prefer RSUs for their simplicity and stability.
Matching Equity to Company Stage
When deciding on an equity model, the stage of your company plays a crucial role. As your startup grows, the approach to equity evolves to match changing needs and resources.
Options for Early-Stage Companies
In the early stages, startups often lean toward stock options - namely NSOs (Non-Qualified Stock Options) and ISOs (Incentive Stock Options). These options help balance growth goals with limited resources. Typically, startups allocate around 13% to 20% of their equity for employee compensation. Early employees often receive larger portions due to the higher risks involved.
Stock options are a practical choice for early-stage companies because they:
- Help conserve cash.
- Provide potential upside without immediate tax burdens.
- Align employee success with the company’s growth.
RSUs for Growth-Stage Companies
As companies move beyond the startup phase, equity strategies often shift toward RSUs (Restricted Stock Units). RSUs offer several advantages:
- Simpler valuation: RSUs reflect the current stock value, avoiding complex pricing.
- Lower equity usage: Fewer shares are needed to deliver the same value.
- Improved retention: Employees see immediate, predictable benefits.
- No exercise costs: Shares are distributed automatically.
Comparing Equity Types by Company Stage
Here’s a quick comparison of equity types based on the company’s growth stage:
| Company Stage | Preferred Equity Type | Key Benefits | Considerations |
|---|---|---|---|
| Early-Stage | Stock Options (NSOs/ISOs) | Conserves cash, offers upside, tax flexibility | Higher risk for employees, exercise costs |
| Growth-Stage | RSUs | Predictable value, better retention, no costs | Limited upside, immediate tax implications |
| Mature | Mixed approach | Matches varied employee preferences | More complex to manage |
Each stage requires careful planning to address tax and legal compliance, ensuring the equity strategy aligns with long-term goals.
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Tax Rules for Each Option Type
Tax rules play a big role in equity compensation decisions, affecting both employees and companies differently depending on the type of option.
Employee Tax Guide
How and when employees are taxed depends on the equity type. Here's a breakdown:
| Equity Type | When Tax Applies | Tax Rate | Details |
|---|---|---|---|
| NSOs | At exercise | Ordinary income | Taxed on the difference between fair market value (FMV) and the strike price, subject to employment taxes |
| ISOs | At sale* | Capital gains | No tax at exercise under normal rules, but the spread might trigger Alternative Minimum Tax (AMT) |
| RSUs | At vesting | Ordinary income | FMV at vesting is taxable as income |
*For ISOs, while there’s no regular tax at exercise, the FMV spread may count toward AMT.
For example, if you exercise 1,000 NSOs at a $5 strike price when the FMV is $15, you’ll owe taxes on the $10,000 spread ($15 minus $5, multiplied by 1,000).
Company Tax Effects
The tax impact on companies also varies:
- NSOs and RSUs: Companies can claim a tax deduction when employees report income.
- ISOs: These don’t provide companies with a tax deduction, even though they can be advantageous for employees.
Employers must also handle payroll taxes, including:
- 6.2% for Social Security (up to $137,700 of earnings)
- 1.45% for Medicare
Tax Planning Methods
Understanding these rules can help employees and companies plan smarter. Here are some strategies:
- For ISO Recipients: Consider exercising early to manage potential AMT exposure and gain flexibility for handling taxes.
- For RSU Recipients: Spread vesting events across tax years, sell vested shares in years with offsetting capital losses, or donate shares to charities for deductions.
- For Companies: Ensure accurate tracking for tax forms like W-2, Form 3921, and Form 3922.
Always consult a tax professional to navigate these complex rules effectively.
Legal Requirements
Once you've tackled tax considerations, it's crucial to ensure your equity compensation plan complies with legal standards. Equity compensation must align with federal and state securities laws to protect both your business and employees.
SEC Rules Overview
The Securities and Exchange Commission (SEC) outlines equity compensation rules under Rule 701 of the Securities Act of 1933. This rule applies to private companies offering securities as part of compensatory benefit plans. Here's a breakdown of the key requirements:
| Requirement Type | Details | Threshold |
|---|---|---|
| Issuance Limit | Maximum securities that can be offered over 12 months | Largest of: $1,000,000, 15% of total assets, or 15% of any class of securities |
| Disclosure Threshold | Additional disclosures required when the issuance exceeds a set threshold | Over $10 million in a 12-month period |
| Documentation | Required materials for compliance | Includes compensatory benefit plan, financial statements, plan summary, and risk disclosures |
If your company issues more than $10 million in securities within a 12-month period, you’ll need to provide comprehensive documentation. This includes a detailed compensatory plan, current financial statements, a plan summary, and a disclosure of key risks.
For instance, Zenefits faced a $450,000 fine from the SEC in 2017 for failing to comply with securities laws when issuing RSUs.
Legal Support Needs
Navigating federal and state regulations can be challenging, so working with legal experts is essential. Here's how to stay compliant:
Federal Compliance
- Collaborate with securities law specialists to structure your equity plan properly.
- Maintain detailed records of all issuances and their values.
- Regularly monitor your use of Rule 701 to ensure you don’t exceed disclosure thresholds.
State Requirements
- Verify compliance with state-specific "Blue Sky Laws."
- Understand the regulations for each state where equity recipients reside.
- Submit any required state exemptions.
"Companies that compensate employees with such equity, either directly or indirectly, must be mindful of the complex interaction between federal and state securities laws." – Masuda Funai Eifert & Mitchell Ltd
To protect your company, consider these best practices:
- Work with experienced startup attorneys to draft equity agreements.
- Update your cap table regularly to track ownership changes.
- Conduct compliance audits periodically.
- Train key team members on equity policies and procedures.
One notable legal update: the 2018 Economic Growth, Regulatory Relief, and Consumer Protection Act raised the disclosure threshold from $5 million to $10 million. While this change offers more flexibility for growing businesses, it highlights the need for ongoing legal vigilance in managing equity compensation programs.
Decision-Making Steps
When crafting an equity compensation plan, it's essential to weigh factors that benefit both your company and its employees.
Company and Employee Needs
Start by evaluating your company's stage, valuation, cash reserves, and potential dilution. For example, early-stage startups often allocate around 13–20% of their equity to pools.
Key considerations for your company:
- Cash reserves available for compensation
- Current valuation
- Estimated timeline to exit (industry average is 7–8 years)
- Expected dilution (roughly 25% per funding round)
For employees, think about:
- Balancing competitive salaries with equity trade-offs
- Individual tolerance for risk
- Career stage and long-term goals
"What's the cash consideration an employee is giving up to work with you?" - David Steinberg
Once you've evaluated these factors, assess how different equity types align with these needs.
Option Comparison
Using the tax and legal frameworks discussed earlier, you can tailor your equity strategy to fit your company's unique situation. Here's a quick comparison:
| Equity Type | Best For | Key Benefits | Key Decision Points |
|---|---|---|---|
| ISOs | Early-stage startups | Tax advantages and employee motivation | $100,000 annual limit per employee |
| NSOs | Growth companies | Flexibility and tax deduction for employer | Immediate taxation on exercise |
| RSUs | Later-stage companies | Clear value and retention benefits | Higher immediate tax impact |
"Stock options give recipients more choice and more flexibility, particularly with a company that has an uncertain future." - Lisa Gorrin
Understanding the strengths and limitations of each option will help you create a plan that fits your team and company goals.
Creating a Mixed Plan
A well-rounded equity plan should address the varying roles and priorities within your organization.
Strategic Implementation
- Align equity grants with your company's mission and growth goals.
- Communicate openly about how equity decisions are made.
"It's important to be equitable and transparent about what's happening. That means telling them, 'We have set aside this much in an employee equity pool and you are either getting X percent of the pool or Y percent of the company - and we think that's reasonable or higher than market rate.'" - Joe Beninato
Practical Considerations
- Define clear vesting schedules and exercise windows.
- Document equity allocations thoroughly.
Balancing equity compensation requires thoughtful planning and regular adjustments to meet the changing needs of both your company and its employees.
Next Steps
Once you've assessed your equity strategy, it's time to move from planning to action. As Morgan Stanley highlights, achieving success requires both detailed preparation and precise execution.
Lay the Groundwork
Collaborate with legal experts to draft equity agreements, establish vesting schedules, outline exercise procedures, and ensure compliance with SEC regulations.
Create a Clear Framework
Here’s a breakdown to help you structure your equity program:
- Valuation: Get a company valuation before issuing the first grant.
- Documentation: Finalize offer letters and agreements within 2–4 weeks.
- Communication: Develop educational materials for employees in 1–2 weeks.
- Implementation: Set up an equity management system in 2–3 weeks.
"Secure your company valuation early to streamline the process." - Chris Wentz, founder of EveryKey
This framework sets the stage for a well-organized equity program.
Educate Your Team
Make sure employees understand the benefits and responsibilities of the program. Training sessions can clarify key details and help employees feel confident in their participation.
"It's necessary to have clear communication with your employees about the details of the program, including its benefits but also its requirements." - Meredith Graham
Establish an Ongoing Review Cycle
After launching your program and educating employees, set up a regular review process to keep everything on track. This should include:
- Conducting pay equity analyses to ensure fairness.
- Updating compensation benchmarks to stay competitive.
- Evaluating the need for equity updates or refreshes.
- Reviewing vesting schedules and exercise windows.
"Employee equity is super important. You want to make sure that employees, especially early employees, who are making a huge commitment and taking a huge risk to bet on your startup are compensated for and have the upside for that in the long run." -
