Why Start-ups Grant Stock Options

Although public companies have largely shifted from stock options to RSUs, this is not the case for private companies. When corporations in the private sector offer equity to employees, they often do so in the form of stock options. In this blog, we discuss why this is.

Let’s Compare: Options vs. RSUs

The TL:DR answer is that stock options make sense when the granting corporation expects to experience significant growth. When this isn’t the case, RSUs can be a better vehicle for delivering equity.

Stock options involve more risk than RSUs. For stock options to produce a return, the company must experience growth. Unlike RSUs, if the company’s stock price remains flat or declines, stock options are worthless. But because of this risk, stock options are highly leveraged vehicles. When the stock underlying the option grows significantly in value, stock options can deliver a return that exceeds the return of RSUs.

Let’s Run Some Numbers

How much growth is necessary will vary by company, but it is easy to calculate once you know the fair value of the stock option and the comparable RSU.

For example, let’s say both an RSU and a stock option are granted by the same company when the stock is worth $1 per share. Let’s also assume that the fair value of the stock option is 60% of the stock price on the date of grant. (This fair value would be calculated using an option pricing model, usually the Black-Scholes model, but the fair value calculation isn’t the point of this example, so let’s just assume I did the math and came up with a fair value of $0.60 per share.)

The target value for both vehicles is $10,000. As a result, the RSU will give the employee the right to 10,000 shares ($10,000 divided by $1 per share), and the stock option will give the employee the right to 16,667 shares ($10,000 divided by $0.60 per share). The per-share value of a service-based stock option will always be less than the per-share value of an RSU granted on the same day, so the stock option should always cover more shares.

Now that we’ve established the size of the grants, let’s look at the value of each vehicle assuming varying amounts of stock price growth:

• If the stock price doubles, to $2.00 per share, the RSU will be worth $20,000 ($2 per share multiplied by 10,000 shares), and the stock option will be worth $16,667 ($2 less $1 exercise price per share, multiplied by 16,667 shares). In this scenario, the RSU is the better choice.
• A stock price of $2.50 is our breakeven point. If the stock price grows to this level, both vehicles are worth $25,000 ($2.50 multiplied by 10,000 shares for the RSU; $1.50 multiplied by 16,667 shares for the option). In this case, both vehicles are equally good choices.
• If any stock price growth in excess of $2.50 is achieved, the stock option will deliver a greater return than the RSU. For example, if the stock price appreciates to $10 per share, the RSU will be worth $100,000, but the stock option will be worth $150,000 ($9 per share multiplied by 16,667 shares).
• The more growth the company experiences, the greater the difference between the two vehicles. If the stock price appreciates to $50 per share, the RSU will be worth $500,000, but the stock options will be worth $816,667.

What If the Stock Price Doesn’t Grow?

If the stock price doesn’t increase in value, the RSU is the better choice. In our example, if the stock price remains at or drops below $1 per share, the option delivers a return of $0, but the RSU still delivers a return equal to the current stock price. If the stock price declines to $0.80, the RSU is still worth $8,000.

Start-Ups and Stock Options

Start-ups that are on a trajectory to eventually go public are expecting to experience significant growth. Early-stage companies expect (well, hope) to experience exponential growth. Moreover, if they don’t experience that growth, there’s a real chance they won’t get the funding they need to stay in business—in which case, even their RSUs would be worthless. Thus, start-ups often feel that stock options are the right equity vehicle for them.

As start-ups mature and experience that growth, however, they may shift to RSUs, as described in the NASPP Blog entry “From Startup to Unicorn: Why the Shift to RSUs?”

There are other reasons stock options make sense for early-stage companies:

• Cash Flow: If employees choose to exercise their stock options, the cash they pay (i.e., the option price) can be a valuable source of capital for the company.
• Tax Withholding: Collecting taxes on RSUs can be a significant challenge, especially for private companies. There’s no market in which the stock can be sold to cover the taxes, and start-ups may not have sufficient cash to withhold shares to cover the taxes. Granting ISOs, which are not subject to tax withholding, can help mitigate this problem.
• Early Exercise: Allowing employees to exercise prior to vesting (when the stock value is still equal to the exercise price) and file Section 83(b) elections—as described in the NASPP Blog “ Understanding Early Exercise and 83(b) Elections”—can allow all that growth, when the company eventually goes public, to be taxed as long-term capital gain.
• IPO Horizon: Granting double-trigger RSUs (that vest only in the event of an IPO or change-in-control) can help mitigate tax withholding challenges for late-stage companies because federal income tax isn’t due until the IPO/CIC. However, to achieve this deferral, award terms generally must require the IPO/CIC to occur within ten years of the grant date. This probably isn’t reasonable for early-stage companies. Stock options, which employees can choose to exercise to avoid expiration, may be preferable.

Learn More

My examples comparing stock options to RSUs are from the NASPP course "Equity Compensation Fundamentals - Private Companies." Register today to learn more about the choices private companies make for their equity programs.