Employee Equity Overview: Common Stock, Options and RSUs

In this guide, we’ll walk you through each type of equity that’s commonly granted to employees at various stages of a private company: Common Stock, options, and Restricted Stock Units (aka RSUs).

Common Stock

Private startups often have two overarching types of stock: Common Stock and Preferred Stock. Usually, investors receive Preferred Stock and employees receive Common Stock. You can read more about Preferred Stock and its various special rights and protections here*. 

Holders of Common Stock are true stakeholders of the company from the moment their stock is granted, even if it’s subject to vesting - they immediately have voting rights and other legal rights associated with stock ownership. This isn’t true for options (see below), which do not confer any actual ownership of the company until / unless they’re exercised into Common Stock.

Recipients of Common Stock need to purchase it at the time of grant, usually at the Fair Market Value (“FMV”) of what the stock’s worth at the time. The FMV is typically determined by the company’s Board of Directors, often with the help of a third party valuation provider. Because recipients of Common Stock have to pay for it up-front, Common Stock is usually issued relatively early in a company’s life, when the stock’s value is low (and therefore the required purchase amount is small). Once the FMV of the stock is high enough that the purchase price would be difficult for folks to pay, companies often switch to granting options instead.

Note that, for recipients of Common Stock that’s subject to vesting, it’s often very beneficial to file an 83(b) Election with the IRS within 30 days of the stock grant date. More on 83(b)s here**.

‍Options

Stock options, or just “options,” are a contractual promise from the company that you’ll be allowed to buy Common Stock shares in the future at a certain predetermined price (the “exercise price” or “strike price”). As we mentioned above, optionholders are not true stakeholders in the company; for example, they don’t have voting rights. All they have is a contractual right to buy stock in the future, if they want to.

There are the two general types of stock option: ISO (incentive stock option) and NSO (nonqualified stock option). The main difference between them is that ISOs often get more favorable tax treatment, and ISOs can only be given to people who are employees of the company at the time the option is granted. Consultants, advisors, independent directors, etc. would all only be eligible for NSOs. There’s a bunch more nuance here that we won’t touch on, but the links we provided above are good further reading.

Here are some helpful definitions:

• “Exercise”: When you exercise an option, that means you’re choosing to pay the pre-set exercise price in order to convert your option shares into actual shares of Common Stock. Note that you don’t need to exercise all of your options at once; you can exercise as many or as few as you want, so long as they’re eligible for exercise (i.e. they’re vested or early-exercisable; see below).
• “Exercise Price” aka “Strike Price”: As we noted above, the “exercise price,” or “strike price,” is the price per share that you need to pay in order to convert your option into stock. The exercise price is set when the option is granted, and it must be set at whatever the FMV of the company’s Common Stock is at that time. 

So, an option’s value comes from the expectation that the value of the company’s stock will increase between the time your option is granted and the time you exercise it into stock. In a scenario where the company’s value increases and you choose to buy stock via option exercise, you don’t pay the higher price that the stock is actually worth at that moment; you get to pay the lower exercise price that you locked in earlier, when the option was first granted to you.

Example: If you received 100,000 options with a strike price of $0.01 each, you’d need to pay $1,000 if/when you exercise all of those options into stock. If the stock were worth $0.10/share when you exercised your options, you’d effectively be getting a 90% discount on the price; you’re only paying $0.01/share when it’s really worth $0.10/share.

• “Underwater”: An option is “underwater” if its exercise price is higher than the current FMV of the company’s Common Stock. You probably wouldn’t exercise an underwater option, since you’d be paying more for the stock than it’s worth.
• “Option Pool”: The “option pool” is the shares that the company has set aside to be available for issuance as option grants. The available option pool is a line item on the company’s capitalization table, and represents a % ownership of the company. 
• Since the number of available options in the pool decreases every time an option grant is made, companies periodically “refresh” (i.e. increase) the pool in order to ensure that enough shares are available for future grants. Option pool refreshes are often done in connection with financing rounds. 
• “Vesting” and “Acceleration”: Read about vesting and acceleration here. Note that you can only exercise vested options (unless you have the right to “early exercise” - see below).  
• “Early Exercise”: This is an exception to the “you can only exercise options if they’re vested” rule. If an option grant includes the right to early exercise, that means the optionholder can exercise unvested options into stock as well as vested options. More on early exercise here.
• “Post-Termination Exercise Period”: Also just referred to as an option’s “exercise period,” this is the period of time in which you’re allowed to exercise your vested options after you leave the company. If you don’t exercise within the exercise period, you forfeit them***. 

There are two things you cannot change about an option once it’s granted:

1. Exercise price cannot be changed at all****.
2. You also can’t really “change” the number of options in a grant, either. If the Board wants someone to have more options, they’ll just issue a new grant for the additional amount. If the Board wants someone to have fewer options, they’d need the optionholder to agree to give up the options they hold.

More Options Info

Startups usually establish option plans soon after they’re incorporated (or even as part of the initial incorporation process). Usually, at incorporation, the founding team will receive Common Stock at a negligible price, and then the company transitions to granting options soon afterward. Stock options are the most typical way to incentivize startup employees with equity until the company is big enough to switch to RSUs (see below). The company’s Board of Directors needs to approve all option grants, including the details thereof (like share amount, vesting schedule, any acceleration, and length of post-termination exercise period). 

What Happens to Options When the Company is Acquired?

Option treatment in a sale is almost entirely dependent on the specific terms of the transaction. Most typically, options that are vested are paid out by the acquirer as part of the sale (net of the exercise price that you owe for them). Unvested options are usually just canceled. The available option pool, which hasn’t been granted to anyone yet, just disappears.

Restricted Stock Units (aka RSUs)

Restricted Stock Units, or RSUs, are a form of employee compensation. An RSU is the right to receive stock whenever the RSU vests (at which point it automatically turns into stock). RSUs are typically used by later-stage private companies, and by public companies. 

It might be helpful to conceptualize RSUs as basically the same as options, except they have a $0 exercise price and they are automatically “exercised” into stock when they vest. Some people also find it useful to think of them as a bonus payment that they’re required to spend on purchasing company stock.

While RSUs give an employee interest in company stock, they have no tangible value until they vest and turn into stock. The RSUs are assigned a fair market value when they vest. Upon vesting, they’re considered income, and a portion of the shares is withheld to pay income taxes. The employee receives the remaining shares and can sell them at his or her discretion. Note that RSUs can’t be sold before they’re vested.

Since this site’s focus is on guidance for earlier-stage companies, we kept this RSU section pretty concise. But, here is a helpful article on RSUs, which includes more detail.

NOTE* Sometimes you'll hear people refer to Common Stock as "restricted stock." "Restricted stock" is just a term for Common Stock that is subject to vesting; and, since it's typical for most Common Stock to have vesting restrictions, people often use the two terms interchangeably. You can read more about vesting restrictions [here - insert link to Vesting article]).

**Fair market value, or FMV, is typically determined by a 409A Valuation, which is a third-party appraiser valuation of the Company’s Common Stock. The "409A" is in reference to a section of U.S. Internal Revenue Code.

409A Valuations are very important, because the company must set option exercise prices at whatever price its current 409A Valuation says its Common Stock is worth. 

409A valuations expire after 1 year, or SOONER if a major company event has happened that could reasonably be assumed to change the company’s value (e.g. a financing). So, companies should get a new 409A after every financing.

***Many option plans require that vested options be exercised within 90 days of termination, or else they expire. But, there is a recent trend for companies to extend that expiration date (which can legally be extended to up to 10 years after the option was granted). This is better for optionholders, since it gives them more time to get the money together if they want to pay to exercise their options into stock, but it’s not great for companies because it leaves potential stock ownership up in the air for a long time.

Companies can extend the exercise period of options on a case-by-case basis, or company-wide. If you're considering this (especially the company-wide approach), definitely discuss it in depth with your lawyers and Board members before making any decisions.

****You might have heard of "option repricings," which would suggest that the exercise price of an option CAN be changed. However, "repricing" is a misnomer here. What actually happens during an option repricing is that the company cancels existing options and replaces them with entirely different options (with a different exercise price). Option repricings are complex and relatively rare.

Disclaimer: The content provided in the Amplify Legal Hub is intended for informational purposes only and should not be construed as legal advice. Always consult a qualified legal professional for advice tailored to your specific situation.