Equity compensation comes in several forms, the most common of which are stock and options. The fundamental difference between the two is that the recipient of a stock grant owns the stock immediately, whereas the recipient of options has the right to purchase stock at a pre-determined price, but is not yet a stockholder. Let’s look at each of these forms in more detail.
An option represents the right to purchase a certain number of shares of stock at a locked-in, pre-determined price (the “exercise price” or “strike price”). In most instances, the exercise price must be equal to or greater than the “fair market value” of the stock on the day the company approves the grant. “Fair market value” is the price that a reasonable person would pay for the stock as determined by either the public markets or the company (see this article on valuing your equity on Paysa for more information). Purchasing some or all of the stock underlying an option at the strike price is referred to as “exercising” the option.
Option grants usually come in two types, incentive stock options (“ISOs”) and non-statutory options or non-qualified stock options (“NSOs” or “NQSOs”). Only an employee can receive an ISO, whereas anyone who provides services to the company can receive an NSO. The other main difference between ISOs and NSOs is the preferential tax treatment given to ISOs. See the chart at the end of this post if you’re trying to decide between an ISO and an NSO.
When a company sells stock, the purchaser becomes the owner of stock and thus a stockholder. A company may designate and sell different classes of stock, the most typical of which are Common Stock and Preferred Stock. Common Stock is the most basic form of stock and is usually held by current and former employees, contractors, advisors and directors. Preferred Stock, on the other hand, is generally reserved for investors, strategic partners and financial institutions. Depending on the stage of a company, it may have several series of Preferred Stock named in accordance with each completed funding round (i.e. Series Seed Stock, Series A Stock, Series B Stock and so on). While the law provides certain rights to all stockholders, Preferred Stock also carries special negotiated rights that are not applicable to the Common Stock.
Companies generally only grant stock to employees at a very early stage – sometime between incorporation and the first funding round or major company milestone. The company may either grant common stock in exchange for services or sell common stock in exchange for cash or something else of value. When an employee receives a stock grant for services, the full value of the grant is taxable as ordinary income. When the stock is paid for with cash, on the other hand, tax is payable on the difference between the price of the stock and the fair market value of the stock on the day it is purchased. And because stock must be purchased within 30 days of the company’s approval of the sale, this difference is usually zero. However, be aware that grants subject to vesting are taxed differently (read more here on vesting).
Restricted Stock Units
RestrictedStock Units (“RSUs”) are an agreement by the Company to issue the employee shares according to a vesting schedule. Each time the employee vests in shares, the Company will grant those shares. The employee is then required to pay ordinary income tax on the current value of the granted shares. RSUs are largely used by public companies and more established companies with higher valuations. When the shares underlying an RSU vest, the company may withhold a portion of the shares to pay for the necessary taxes. Otherwise, if the Company is public, an employee may chose to immediately sell a portion of the shares to cover the tax liability.
A small number of start-up companies are organized as Limited Liability Companies, or LLCs. These companies issue units rather than stock or options. LLCs are fairly rare in the tech world these days, particularly ones that are, or strive to be, venture backed, so you’re unlikely to encounter this type of equity. However, if you are offered employment and equity in an LLC, be sure to ask for a detailed explanation of how the units are structured or even better ask for a copy of the LLC Agreement, which will detail all the rights and restrictions on units. LLCs do not have to abide by the same rules that a traditional C-Corporation must follow and no two LLCs structure units the same. Be sure to do your due diligence before accepting an offer that includes a unit grant from an LLC.
So why do you care what kind of grant you get? Do these distinctions really make a difference? Is one type of equity inherently better than another? There is no quick answer to these questions, rather it’s a function of your and the company’s current status. Read more about the different types of equity on Paysa. This handy chart also helps determine what type of option is best for you, ISO or NSO.