When would a company use restricted stock awards (RSAs) instead of stock options?

Takeaway: Startups should generally issue RSAs while the price of the stock is low enough for employees and consultants to purchase the shares directly. The turning point is usually when the startup raises a priced equity round of financing (e.g., a traditional VC financing). After that, you’ll need a 409A valuation and the price is generally too high for people to come out of pocket, so companies begin issuing stock options instead.

Startups often use equity compensation to attract and retain top talent, and two common types of equity compensation are restricted stock awards (“RSAs”) and stock options. While both types of equity compensation can be effective tools for incentivizing employees, there are some situations where a startup may choose to issue RSAs instead of stock options. In general, issuing stock options is more favorable to the company for reasons outlined below while issuing RSAs can be more favorable to the recipient in some circumstances.

There are limited situations in which RSAs are preferable from a company’s perspective. The most common situation when employees or service providers prefer RSAs is when the price of the stock is low.

When the price of the stock is low

Employees and service providers may prefer to receive RSAs while the price of the stock is low because, all else being equal, most would prefer to hold stock instead of stock options. Holding shares of stock starts the holding period clock for qualified small business stock (QSBS) treatment and long-term capital gains tax treatment.

On the other hand, here are some of the situations where a startup may issue stock options instead of restricted stock awards:

When it is not specifically more advantageous to issue RSAs

In general, stock options should be issued when there is not a specific reason to issue RSAs. Given that the most common reason to issue RSAs is when the price of the stock is low, stock options are the primary vehicle for employee and service provider equity compensation, particularly once the company matures.

Stock options typically expire by default three months after the employee or service provider’s termination of service. The unvested portion of the option and any unexercised portion of the option then return to the company’s equity incentive plan, increasing the number of shares that the company has to allocate to other employees and service providers. In this sense, stock options are more favorable to companies and RSAs (which, to the extent they are vested, are shares that the employee or service provider actually owns) are more favorable to employees and service providers.

After a preferred stock financing

Preferred stock financings set a valuation on the company’s stock. After a financing, the company will obtain a 409A valuation, which it will use as a reference point to set the price of RSAs and stock options that it subsequently issues. This 409A valuation will typically have a price that is too high for employees and service providers to pay for their stock out of pocket. As a result, stock options become a more attractive mechanism to provide employees and service providers with equity compensation.

Conclusion

There are limited situations where a startup may choose to issue RSAs instead of stock options. The primary one is when the price of the stock is low enough for the service provider to purchase the shares. While both RSAs and stock options can be effective tools for incentivizing employees, startups should work with qualified legal professionals and carefully consider their specific goals and circumstances when deciding which type of equity compensation to offer.