6 min read
Equity compensation helps startup founders compete for top talent and incentivize performance while preserving cash for growth. But choosing the best type—typically stock options or restricted stock units (RSUs)—for a startup’s stage and goals is critical.
Gemma Marshall, Head of Customer Success, Cap Table at J.P. Morgan Workplace Solutions, shares insights on designing strategic equity compensation packages and managing equity compensation effectively.
What is an RSU?
Restricted stock units are company shares awarded to employees after they meet agreed-upon conditions. Vesting, or ownership, is often based on:
- Time: An employee must stay with the company for a specific period to earn shares.
- Performance: Shares are earned when the employee or company achieves a target, such as a sales goal for an individual or a liquidity event for a startup.
RSUs have no upfront cost. In the U.S., shares delivered at vesting are taxed as ordinary income. Selling later can trigger capital gains or losses.
What is a stock option?
Stock options give employees the right to buy company shares at a price set when the options are granted, known as the strike price or exercise price. If the company value climbs, an employee can exercise the option at the lower strike price, profiting from the increase in value. When the company’s value sits below the strike price, the stock options are underwater and have no current exercise value.
Stock options generally have a fixed expiration date, often 10 years from when they’re granted. If an employee leaves the company, any vested options typically must be exercised within a short window—commonly around 90 days—or they lapse. Employees usually forfeit unvested options when they depart the company.
Exercising an option delivers shares. Tax treatment depends on the type of stock option:
- Incentive stock options (ISOs) can be granted to employees. There’s generally no regular income tax at exercise, though alternative minimum tax may apply. Capital gains tax is determined when the shares are sold, subject to holding-period rules.
- Non-qualified stock options (NSOs) can be granted to employees and nonemployees. When exercised, the spread between the exercise price and the current fair market value is taxed as ordinary compensation income. When shares are sold, any gains or losses are generally treated as capital.
In both cases, if employees hold their shares long enough after exercising options, any subsequent appreciation is taxed as long-term capital gains.
RSU vs. stock options: Designing an equity compensation strategy
A startup’s approach to equity compensation often evolves as it grows, beginning with stock options before transitioning to RSUs.
“Many companies begin shifting in late-stage private rounds, such as Series C or D, when 409A fair market value is high and a credible path to liquidity exists, or shortly before or after an IPO,” Marshall said.
But there’s no single right approach to equity compensation. When building a compensation program for a startup, consider:
- Valuation: When a startup has a high valuation, purchasing shares to exercise options can be costly, and employees may see it as a barrier to benefiting from their equity compensation. “If option exercises become expensive relative to wages, RSUs can reduce friction,” Marshall said. But if a late-stage startup’s 409A valuation remains low relative to its perceived upside, the company may continue granting options.
- Expected liquidity timing: Because RSUs are taxed when shares are delivered (often at vesting) with no guarantee of a ready market for shares, they’re more common when a liquidity event is on the horizon or for post-IPO companies. In private companies, granting standard RSUs can saddle employees with significant tax bills on shares they can’t easily sell. To avoid this, private companies often use double-trigger RSUs, which combine time- and performance-based vesting requirements so shares don’t fully vest—and trigger a tax event—until the company experiences a liquidity event.
- Recruiting goals: The type of equity a startup offers candidates sends clear signals about its maturity. “Options signal an earlier stage and higher upside with more risk. They tend to attract candidates comfortable with uncertainty and leverage—often technical hires and early operators,” Marshall said. “RSUs signal maturity, predictability and lower risk, which often appeal to senior leaders and candidates seeking certainty.” Growth-stage startups may choose a hybrid approach, aligning equity compensation with what’s most competitive for each role.
- Administrative readiness: Stock options and RSUs create administrative requirements, though the specific challenges differ. For example, because RSUs are taxed at vesting and NSOs are taxed at exercise, they require the ability to run payroll withholding. Both types of options, meanwhile, require regular 409A valuations to establish accurate exercise prices. With ISOs, companies must monitor an annual cap on the value of an employee’s exercisable ISOs and disqualifying dispositions—ISOs sold before the holding period required to qualify for favorable tax treatment.
- Global footprint: Tax treatment, securities laws and other regulations affecting employee equity vary across countries. RSUs are often simpler to standardize across countries because there’s a more uniform pattern to how they’re taxed. They also lack stock options’ exercise mechanics, which can create local timing and valuation issues.
- Culture considerations: Stock options’ high-risk, high-reward nature can help promote an ownership mindset. RSUs, on the other hand, encourage retention through time-based vesting.
- Dilution impact: Founders often establish a pool of equity that’s reserved for employee compensation, but while both RSUs and stock options cause dilution, there are differences. RSUs create shares predictably as they vest. Options are more variable: They create shares as employees choose to exercise them.
Simplify equity compensation and cap table management with J.P. Morgan Workplace Solutions.
Managing startup equity compensation
Equity compensation is a powerful tool for incentivizing performance and recruiting talent. But managing employee equity can be complex. These best practices help founders avoid equity errors and encourage employees to make the most of their equity compensation:
- Create a disciplined cap table process: When launching a startup, it’s never too early to think about cap table management. “When a startup’s equity plan is spread across multiple spreadsheets and documents, often you find errors in who holds what equity,” Marshall said. “There needs to be a single source of truth for the share plan and how the startup is allocating options, and it’s easiest when it’s in place from the beginning.” Equity compensation platforms including J.P. Morgan Workplace Solutions help companies maintain these critical records, providing clarity and streamlining the fundraising process.
- Be transparent: Publish a clear equity policy covering stock option or RSU grant cadence, vesting standards, performance criteria and post-termination rules. A transparent equity compensation platform that helps employees understand the current and potential future value of their equity can also be motivating. “When you’re working hard late into the night, it helps create an ownership mindset, where you can feel the value in what you’re doing,” Marshall said.
- Keep 409A valuations fresh: Regular 409A valuations keep option strike prices aligned with the company’s fair market value. A startup should get a 409A valuation before issuing its first common stock options, after raising a venture round, on an annual basis (or after material events) and when approaching an exit.
- Offer regular equity education: Startup employees may not have prior experience with equity compensation. Providing education sessions that explain tax timing and liquidity options before vesting, exercise or tender windows helps team members maximize the value of equity they’ve earned. J.P. Morgan Workplace Solutions offers simple, practical resources to make employee education easier.
- Monitor Rule 701 thresholds: Rule 701 exempts sales of securities made to compensate employees, consultants and advisors—not raise capital—from requirements to register the securities with the Securities and Exchange Commission. But there are limits on the amount companies can sell without triggering additional disclosure requirements. Don’t forget to consider state securities laws, known as blue-sky laws, which may have additional requirements.
- Manage equity dilution: While investors often negotiate anti-dilution protections, employee equity typically gets diluted in future funding rounds. Quote option or RSU grants in both shares and percentages, explain option pool increases before equity financing rounds and consider refresh grants to keep compensation competitive. Founders who want to incentivize employees with equity-like compensation without diluting their ownership can consider phantom equity. It offers cash compensation linked to company performance without granting ownership.
We’re here to help
J.P. Morgan helps growing startups design compensation plans that support their broader capital strategy, with streamlined administration so companies can focus on growth.
To discuss your startup’s equity compensation approach, contact a banker.
Contributors
Gemma Marshall
Head of Customer Success, Cap Table, J.P. Morgan Workplace Solutions
JPMorgan Chase Bank, N.A. Member FDIC. Visit jpmorgan.com/commercial-banking/legal-disclaimer for disclosures and disclaimers related to this content.
