When companies grant equity, we typically receive the shares over a period of time or when we hit a particular performance milestone. There are a few ways companies can give equity to us. Understanding the difference helps us understand potential tax implications and start forming strategies to manage the wealth we build through work. Let's take a look at the three different categories of equity compensation.
Stock options are the most common form of equity compensation issued by startups.
Being granted stock options doesn't actually give us the stock; we own the shares once we've paid to exercise the option.
Even though this means that we'd have to pay money out of our own pocket to finally own the shares, we don't have to buy them if we don't want to. We can decide to walk away.
Restricted Stock Award (RSA)
Restricted stock awards are different than stock options as RSAs offer actual shares in the company.
We own the RSA shares when granted to us. In certain cases, RSAs, like options, come at a cost to purchase the shares. The cost is either at a discount or at the fair market value. While that doesn't sound great, RSAs are usually granted to very early employees where the fair market value is near $0. We agree to purchase the shares on the date they are granted to us by accepting the RSA.
Most companies will have restrictions that allow them to repurchase the shares if we leave the company within a certain period of time.
Restricted Stock Unit (RSU)
Restricted stock units or RSUs are similar to RSAs because they also represent shares in the company.
Unlike RSAs, we don't own shares immediately through an RSU. When granted RSUs, the company promises to give us stock if we meet a set condition. The requirement could be to work at the company for a certain amount of time or reach a performance goal. Consequently, we don't receive stock if we fail to meet the conditions.
The most significant difference between RSUs and RSAs is that we don't have to pay anything to receive RSUs once we meet the conditions. As a result, there are some tax implications to be aware of when we receive RSUs.
When to expect each type
Our employers will choose which type of equity compensation to use based on various advantages. In most cases, employers will change their offerings as they grow.
Companies in their infant stages typically issue RSAs to founders and initial hires when it's tough to afford competitive salaries. RSAs are more attractive to us because we end up getting a piece of the pie that turns into a major reward when the company succeeds.
As start-ups grow into early-stage companies, it makes more sense to issue stock options. We get less upside than RSAs; however, the cost to exercise the shares is still affordable.
Once companies mature and are successful, they usually issue RSUs since exercising stock options becomes too expensive for most employees. The growth of the company has also slowed, making it harder for the options to be valuable.
Knowing the type of equity compensation we've received is the first step in unlocking the potential we've been granted. The next step is to maximize the benefit by minimizing the taxes we have to pay. Take a look at the lesson about the taxes owed to sell stock options and RSA and RSU tax strategies for more.