This alert is Part II of a three-part Goodwin series on double-vest restricted stock unit awards (Double-Vest RSUs). As discussed in Part I, Double-Vest RSUs are again making headlines, largely as a result of a recent confluence of factors, including the following:
- The term/expiration date of some older Double-Vest RSUs is approaching.
- Many companies that awarded Double-Vest RSUs may be confronted with less access to capital markets, which may limit the opportunity to seek an IPO prior to term/expiration.
- More active secondary markets for private companies have developed since the Great Recession, which may entice Double-Vest RSU holders to seek liquidity.
- Pent-up employee desire for liquidity.
Here, we provide context to answer the question “Why do private companies shift from stock options to Double-Vest RSUs?” by delving into the advantages and the disadvantages of these awards relative to stock options.
What Are the Advantages of Double-Vest RSUs?
Most startup companies in the technology sector grant restricted stock or stock options to the company’s earliest employees, and regularly grant stock options to all new hires as the company scales up. Many mature startups and other high-value pre-IPO companies have shifted away from stock options to Double-Vest RSUs to attract and retain talent in lieu of, or in addition to, stock options. This pivot primarily occurs due to the advantages that Double-Vest RSUs offer to both employers and employees relative to stock options as the company matures, namely:
- Stock options generally have an exercise price set at the current fair market value of a company’s common stock on the date of grant. Future stock option value is derived from the appreciation of the company’s common stock over the exercise price. Employees and other service providers at high-value companies may perceive less opportunity for future appreciation in the company’s common stock because the pace of company growth (as reflected in its stock price) is generally expected to slow over time, and employees may become increasingly concerned that a stock option with a higher exercise price is not affordable and is unlikely to ever be exercised. As a result, an equity compensation package focused solely on stock options may become less attractive to, and less likely to retain, talent at high-value companies.
- Companies typically offer fewer Double-Vest RSUs than stock options (i.e., Double-Vest RSUs and stock options usually are not granted on a 1:1 basis) because Double-Vest RSUs deliver the full value of a share and not just the value of appreciation over an exercise price. A smaller number of Double-Vest RSUs would normally equal the same potential value as a larger number of options. For these reasons, Double-Vest RSUs can result in less dilution to the company because fewer shares are granted.
- The holder of a Double-Vest RSU can receive value when the award vests and is settled (even if the company’s common stock value has declined following the grant date) without having to fund an exercise price. Stock options, on the other hand, can fall “underwater” and fail to deliver any value, meaning that if a company’s value declines, the exercise price of a stock option may be higher than the current value of the company’s common stock.
- Companies are not required to engage an independent third party to provide a Section 409A valuation prior to grant of a Double-Vest RSU because there is no exercise price requiring a determination of fair market value of the company’s common stock.1
- Without a requirement to determine fair market value for purposes of setting an option exercise price, companies can avoid administrative delays in granting Double-Vest RSUs.2
- Double-Vest RSUs can be easier to administer than stock options while a company is privately held. For example, there should be no payroll administration until after a Liquidity Event3 occurs.
What Are Some of the Practical Challenges of Double-Vest RSUs?
- If a Liquidity Event does not occur prior to the term/expiration date of a Double-Vest RSU, then a Double-Vest RSU must be forfeited because the expiration date/term likely cannot be extended under tax laws.4
- Startup companies with “in the money” stock option awards increasingly are offering their employees an opportunity to sell or “cash out” before a Liquidity Event occurs through a secondary sale (such as a sale to a third-party investor or a tender offer). With very limited exceptions (to be described in Part III of this series), Double-Vest RSUs generally cannot participate in these secondary sales because doing so potentially could result in adverse tax consequences to the holders of Double-Vest RSUs (i.e., loss of the substantial risk of forfeiture and thus accelerated tax consequences), including holders who do not participate in a secondary sale or tender offer.
- Double-Vest RSUs may require the collection of employment taxes upon vesting and are taxed as wages for income tax purposes at the time shares are issued or settled. This means there is no opportunity for capital gains treatment on the value of a Double-Vest RSU (including no opportunity to file a Section 83(b) election), except for gains that accrue after the award is settled in shares. This also means that an employer may need to align vesting and settlement to avoid having employment and income taxes calculated and collected on different dates.
- In an IPO setting, managing federal, state, and local tax withholding requirements for employees during any post-IPO lockup period imposed by an underwriter (which customarily lasts six months) may be complicated. Taxes for employees can be paid through one of the following methods: (a) the employee pays cash (check or cash equivalent) to cover the applicable taxes; (b) the company net withholds by taking back shares underlying the Double-Vest RSU with a value equal to the taxes due, and the company pays cash to the tax authorities on behalf of the employees5 , or (c) an exception to the lockup period is negotiated with the company’s underwriters prior to the IPO to allow sales to cover taxes.
- If the Liquidity Event of Double-Vest RSUs is satisfied upon a change in control, the value of the vested RSUs will likely be included as a “golden parachute payment” for purposes of Internal Revenue Code Section 280G. This may result in adverse tax consequences for private company executives (absent proper stockholder approval of such payments, including disclosure of potentially outsized payment amounts to the company’s stockholders).
Next Up…Part III
In Part III of this three-part series, we will discuss mitigation strategies for dealing with the problem of expiring Double-Vest RSUs.
Please note that fair value still must be determined for accounting purposes under FASB ASC 718.
With stock options, there generally is a requirement that the exercise price be set at no less than 100% of fair market value of common stock on the date of grant to exempt the option from the requirements of Section 409A. So, if a company does not have a current valuation report to support compliance with this rule, it may need to delay the grant of stock option awards until fair market value can be properly determined.
A Liquidity Event generally refers to a performance-based condition tied to the occurrence of a liquidity event that must occur prior to a specified expiration date.
 This issue is the focus of Part III of this series and is of particular concern as some private companies in recent years have delayed an IPO transaction for reasons that often are outside of the company’s control.
 Net settlement assumes that the company has sufficient cash reserves to make such payments, and may result in disclosure related to the use of proceeds in the company’s Form S-1 filing with the SEC at the time of an IPO.