Restricted Stock Awards for early-state startups.
January 30, 2022
Occasionally it happens that we encounter a startup that’s very early-stage but that’s on a clear upward trajectory. They’re in the process of hiring their first few U.S. employees/contractors and begin investigating the various equity-related incentive choices available to entice their first non-founder people. They might have already secured a few SAFEs (Simple Agreement for Future Equity) which will lock in share issuances at a future valuation, but they have no objective valuation.
The equity incentive choices at this early stage generally boil down to Restricted Stock Awards (RSAs) and Incentive Stock Options (ISOs). Restricted Stock Awards actually grant an employee equity upfront, but the company retains the ability to buy it back (this is the “restricted” part). The company’s right to repurchase the stock terminates on a predetermined schedule (thereby incentivizing the employee to stay working with the company), after which time, the employee owns the stock out right. Restricted Stock Options on the other hand, aren’t equity awards - they’re option awards, which give the employee the option to purchase equity in the future at a set price and upen the occurrence of a particular triggering event (e.g. if the company is acquired). Like RSAs these are on a vesting schedule albeit the vesting is done in a different way.
For the early stage startup, a major factor is valuation - issuing incentive stock options require the company to obtain a valuation (known as a 409A valuation) because ISOs are issued with a base price equal the fair market value of the underlying stock on the date the option is granted. On the other hand, RSAs require no such valuation - when the company is very early stage, hasn’t obtained Series A funding and has no track record of profitability, it’s really not worth much. This is particularly the case where:
The future Series A investors (and SAFE investors) will likely have preferred stock and a liquidation preference, both of which are bad news for common stockholders and drive down the value of their stock;
The restricted stock has no value until it becomes unrestricted (i.e. it can’t be sold), a contingency that might not happen (e.g. the employee could quit before vesting);
Depending on the terms of the shareholder agreement, the employee likely can’t sell the stock until there’s a liquidity event which may never occur;
The company won’t (in all likelihood) be turning a profit/issuing dividends;
Presumably the company has no assets beyond the initial funding which is already in the process of being used.
RSAs are more appealing to employees, are cleaner from a tax perspective (as they’re usually issued for nominal value due to the lack of a fair market value), and are quicker. Moreover, the window to issue them is narrow as once funding is secured, the shares have a fair market value and the recipient is required to account for the stock in their own tax filings. For this reason they’re a useful, if time-limited tool.
