Almost all your points apply exactly equally to restricted stock as it does to options. In both cases you will have a vesting schedule, just in the case of restricted stock it's usually a grant of the shares with no exercise price. In both cases you want to file an 83(b) election so you are taxed based on the FMV of the company when you receive the unvested shares (when the shares are worthless) so that you will only owe capital gains later.
But more importantly, in both cases you end up exactly and equally screwed in terms of you are holding the same class of stock (common) with the same vesting terms (no, single, or double trigger acceleration), all the exact same issues around dilution, liquidity, preferred shares, and unfair buyout terms funneling cash to key executives, etc.
Equity is a massive gamble all around, and there's no magic bullet that I've seen which can defray many of the inherent risks of owning common shares of a private company which has perhaps a 1 in 100 odds of ever seeing a public market or liquidity event that surpasses the total liquidation preferences.
> In both cases you will have a vesting schedule, just in the case of restricted stock it's usually a grant of the shares with no exercise price.
In practice, there are huge differences between them. Generally stock is much friendlier to employees and signals a company/founder which actually values employee ownership.
I'm surprised by the number of companies which try to pull shady stuff like not sharing the exercise price for options that are part of an offer. Lots of people apparently think that employees should value options at a substantially higher value than investors do. I've seen cases where the gap between the 409a price and the last investment is only a few thousand dollars, while the company insists this somehow makes up for a substantially subpar salary.
Equity is a risk, yes, but the status quo is that the risk falls much more on the people least able to bear it. Investors get all sorts of protections, while employees only benefit in a very narrow set of outcomes.
The only downside of early exercise I can see for the company is accounting for the cash and being ready to buy-back unvested shares as-needed. Since the tax implications are potentially massive for the employee, and we're talking de-minimis work for the employer, early exercise should be a standard term on all ISO contracts. I see this as an educational opportunity for Founders, and if you see a contract without early exercise I certainly wouldn't hesitate to question it.
Early exercise is great for the majority of situations. The 100k limit for ISO options can be a potential downside. If there is a spread between the strike price and the FMV, only the first 100k worth of shares will be considered ISOs and the rest will be treated as NSOs. In the case of no early exercise, you could get 100k of ISOs per year for the 4 years.
> So the vast majority of startup employees don't have the fancy tax-avoiding scheme that founders and investors have.
Investors never have vesting on their shares so 83(b) has nothing to do with the preferred stock investors receive. Founders of course do often have vesting and can benefit from filing an 83(b).
> In both cases you want to file an 83(b) election so you are taxed based on the FMV of the company when you receive the unvested shares
Can you do this, though? 83b election with ISOs makes sense because the tax event is employee writing a check to pre-exercise his shares, so a transaction occurs. For RSUs the transaction seems to occur at the time of the actual grant - there's no money changing hands, no transaction on record, and hence no tax event.
Not a tax lawyer, just trying to understand the complexity that I thought I had under control.
Section 83(b) Election
Shareholders of restricted stock are allowed to report the fair market value
of their shares as ordinary income on the date that they are granted, instead
of when they become vested, if they so desire. This election can greatly reduce
the amount of taxes that are paid upon the plan, because the stock price at the
time of grant is often much lower than at the time of vesting. Therefore, capital
gains treatment begins at the time of grant and not at vesting. This type of election
can be especially useful when longer periods of time exist between when shares are
granted and when they vest (five years or more).
Taxation of RSUs
The taxation of RSUs is a bit simpler than for standard restricted stock plans.
Because there is no actual stock issued at grant, no Section 83(b) election is
permitted. This means that there is only one date in the life of the plan on which
the value of the stock can be declared. The amount reported will equal the fair market
value of the stock on the date of vesting, which is also the date of delivery in this
case. Therefore, the value of the stock is reported as ordinary income in the year the
stock becomes vested.
To me that means that Founders shares would be in the form of restricted stock, however RSUs would only be appropriate for liquid (publicly traded) shares.
Thanks for the clarification. Back to the grandparent's discussion, it seems that such election on RSUs is more punitive than on ISOs - an RSU grant to a high-income employee is then taxed as income, potentially as high as 39.6% at federal level (and whatever the state obligations are) versus AMT bill, which tops out at 28%.
However, I still much prefer RSUs over options in the case where you're joining a large/later stage company. Say you go to a Slack or Uber today. They won't (I believe they legally can't?) issue you options below their FMV (fair market value). They will give you some arbitrary/negotiable number of RSUs and options however. Then consider the following scenarios:
(1) The company then IPOs or is acquired several years from now, at double the current valuation. In this scenario, assuming you 83(b)'d and early exercised, you get the favorable tax treatment on the gains for the ISOs. But you're still out the exercise price outlay. The RSUs meanwhile are worth what they're worth, and you are taxed on them at the higher rate and that's that.
(2) The IPO or change of control happens too soon (less than 2 years from date of grant or 1 year from date of 83(b)/exercise). Your fancy options spread is still just ordinary income with no advantage over the RSUs.
(2) The company IPOs or is acquired next year, for the same FMV. Your options are worthless, your RSUs are still worth a goodly amount hopefully.
(3) The company IPOs at half the FMV of when you joined. Your options are worthless, your RSUs are worth something.
(4) The company fails/does a down round/whatever. You are probably wiped out regardless.
The only scenario in which the options are more interesting is as noted, very early stage companies where the exercise price is really small, or insane rocketships with an active secondary market providing real liquidity. Or, I guess when the company itself is holding liquidity events regularly (and even then it's only interesting if the FMV continues to grow up rapidly).
But more importantly, in both cases you end up exactly and equally screwed in terms of you are holding the same class of stock (common) with the same vesting terms (no, single, or double trigger acceleration), all the exact same issues around dilution, liquidity, preferred shares, and unfair buyout terms funneling cash to key executives, etc.
Equity is a massive gamble all around, and there's no magic bullet that I've seen which can defray many of the inherent risks of owning common shares of a private company which has perhaps a 1 in 100 odds of ever seeing a public market or liquidity event that surpasses the total liquidation preferences.