In the immortal words, imprinted in large friendly letters on the front cover of The Hitchhiker’s Guide to the Galaxy – “Don’t Panic”. Even for those familiar with equity, discussions around shifting to a value-based RSU-delivered model can make your head spin.
At some point in the VC-backed life-cycle, we reach the junction point of RSUs vs Options. Is it time to start communicating dollar values? Is there enough upside in the stock to justify Options or should we award RSUs? Is there an IPO on the horizon that means we need to change strategy? Is it becoming difficult to hire using Options? In this blog, I will try my best to demystify some of this. I’ll also intersperse this post with Douglas Adams quotes as it was becoming, well, a little dry…
“I love deadlines. I love the whooshing noise they make as they go by”Douglas Adams – The Salmon of Doubt
First of all, some common terminology:
Stock Options – An option is the right to buy stock at a certain price (the Strike Price). That means that unless the share price is above the Strike Price, they are worth zero. Stock Options are common in the private world as, although they have the potential to be worth nothing, they generally offer a larger potential upside than Restricted Stock Units, since more are awarded. As such, in a high-growth environment where the stock price is likely to grow significantly, Options are a good thing to own.
RSUs – Referred to as either Restricted Stock or Restricted Stock Units. Note that technically there is a difference, just not one worth elaborating on here and I’ll refer to these as RSUs going forward. RSUs are exchanged directly for stock meaning that, unlike options, there is an immediate intrinsic value. RSUs are ubiquitous below the executive level in the public market, the rationale being that in a large established company, there is not enough upside to justify options. They are “Restricted” by time which means that your RSUs may have intrinsic value, but you aren’t allowed to exchange them for shares until they vest.
Honorable mention for PSUs (Performance-Restricted Stock Units) – these have both time and performance restrictions to satisfy before vesting but are uncommon below the executive level and rare in the private market.
409A Price – You’re going to hear this a lot in the private space. The 409A Price or 409A Valuation is the Fair Market Value of the common stock of a company, usually valued by an independent source, and a legal requirement. This is (usually) a relatively conservative valuation. The practical upshot of this valuation for our purposes, is that it typically defines the Strike Price of the option.
The Preferred Price – The preferred price (not to be confused with preferred shares), is defined by the value placed on the stock in the latest round of investment, usually the latest round of VC funding (A, B, C etc.). This is important because it starts to tell us something about the market value of a company – this is what someone external was willing to pay for the stock. Typically this is higher than the 409A price as it reflects an anticipation of future growth, whereas the 409A price is a point-in-time valuation. It is not uncommon for the Preferred Price to be several times higher than the 409A price.
The Spread – This is another term you will hear a lot of in these discussions. The spread is the difference between the 409A price and the Preferred Price. This is important as it reflects potential upside in the share price since the 409A price is typically used to set the Strike Price of an option.
“I refuse to answer that question on the grounds that I don’t know the answer”Douglas Adams
If we go back a few years, life was simple. Private companies awarded options, public companies awarded RSUs, and that was, pretty much, that. Over time, however, late stage private companies have started shifting from Options to RSUs before IPO, and in recent years, this trend has continued with private companies making the transition earlier and earlier in the company life cycle. There are a few reasons for this.
Firstly, the idea of a mysterious number of stock options that may be worth nothing or may turn you into a millionaire, doesn’t quite cut the mustard like it once did. Gone are the days of rock-bottom base salaries with generous option grants. Over time, private company cash pay has moved closer and closer to the public market and employees are wise to the risks of VC-backed companies. Talent will move back and forth between the private and public markets and like it or not, companies need to compete in both. The war for talent has heated up this year and shifting to RSUs enables private companies to go head to head with the public market.
The other challenge is the sheer value of the VC marketplace. The “Unicorn” companies used to be defined as those with a valuation of over $1bn – now that seems like spare change. Remember how shocked everyone was when Mark Zuckerberg paid $1bn for Instagram? The world has changed and late stage private company stock can be worth a lot. What this means is that the traditional model of handing out options based on a percentage of the company, can result in a huge amount of value being offered. Shifting to RSUs, is one way to manage that.
Dilution is also a factor. Dilution, in this context, refers to the amount of stock companies have given/will give out to employees – the share pool is diluted by employee ownership. As private companies mature, revenue streams grow, profit appears (hopefully), and the 409A price starts to close in on the preferred price. The Spread diminishes and an Option becomes less attractive than it once was. To counteract this, a company may need to award more options which increases dilution, or, shift to awarding RSUs. Because of the intrinsic value of an RSU, fewer awards need to be made which has a less dilutive impact on the share pool while delivering an equivalent value.
Finally, there is the problem of understanding. When I asked a business leader recently if they felt that employees understood the values of the options they were being awarded, they responded; “There is too much snake oil in that math”. The problem with an option in a private company, is that no one really knows how much it is worth. We tend to communicate the value in hypotheticals – “If we IPO at $X, it’ll be worth $Y” etc. The problem is that we are up against companies that communicate their equity awards in terms of value and deliver them in RSUs which is, frankly, just simpler. If you are going head to head with a company offering RSUs and communicating the value of the total package, trying to explain the the hypothetical value of a stock option can be tricky.
“It is a mistake to think you can solve any major problems just with potatoes”Douglas Adams – Life, The Universe, Everything
The practical upshot of all of this is that private companies increasingly want to transition to RSUs – Even below the traditional “Unicorn” threshold.
There are counter arguments, of course. An Option in a private company is still an attractive thing. If you believe in the mission, you may well be looking for the higher risk-reward relationship of an Option. If it is entrepreneurial risk-taking mindsets you are looking to attract, taking Options off the table may filter out some of the candidates you would otherwise hire as they seek the higher risk profile of an earlier stage company. So long as the Spread is strong, an Option can encourage the right behaviors and attract the right talent.
Despite the simplicity of communicating the dollar value of RSUs to a candidate, we should also be wary of over-promising and manage the communication carefully. We can create a dollar value for the stock which may be based on the preferred price or an anticipated IPO, but we don’t have to look too far to see how perilous this can be. Uber IPOd at $45/share. By the time the lock-up period was over, the stock was worth $26/share – about 40% less. Sticking with Options allows us to talk to candidates from the perspective of wealth creation without having to hang our hats on a share price that may or may not materialize.
There are also tax and administrative considerations. With RSUs, to get around the taxable event at the time of vesting, a double trigger is common (the company needs to IPO and the RSU will only fully-vest post lock-up). This ensures that an employee isn’t taxed before they can realize the value of their stock. Another option is to allow employees to make an 83(i) election which lets them defer their tax liability for 5 years in certain scenarios. This election requires careful planning, however, to ensure eligibility and employees need to make this election themselves after each award. RSUs are also a little more administratively challenging, although HR systems have made this more straightforward in recent years. Bottom line – engage your Legal Counsel early on to avoid any nasty surprises.
“Let’s think the unthinkable, let’s do the undoable. Let us prepare to grapple with the ineffable itself, and see if we may not eff it after all.”Douglas Adams – Dirk Gently’s Holistic Detective Agency
This is a relatively complex topic and has implications going far beyond rewards. As rewards professionals, it is important to be armed with the considerations for these decisions to help to facilitate the transition – if and when the time is right.