From Startup to Unicorn: Why the Shift to RSUs?

In the world of startups, a small percentage are able to rise to the status of “unicorn,” a feat only achieved once a privately held company eclipses the billion-dollar valuation mark. But as these unicorns mature, they must now begin to navigate the complexities that come with rapid growth, and their strategies, especially in the realm of equity compensation, must undergo a significant evolution.   

This article delves into the world of unicorns and explains why restricted stock units have become the equity of choice for these industry giants. 

The term "unicorn" in the business world is more than just a mythical reference. It signifies rarity, success, and a journey fraught with challenges. For a startup to achieve this status, it means that it has not only survived but thrived, often winning the battle for talent, disrupting industries and rewriting rules. 

In the early stages of these startups, stock options are most often the go-to instrument, as lower valuations typically mean that they are a low-cost way to incentivize employees and entice talent through the potential growth they may experience.   

 

For example, if a company currently has an FMV of 25 cents per share when valued at $5 million, and the company does reach unicorn status, then that means the FMV would surge to $50 per share when valued at $1 billion (please note this example assumes the improbability of zero share dilution). That is a 19,900% increase in value that early-stage employees get to share in, making the cost of exercising their awards pale in comparison to the value received.  

However, once that $1 billion valuation has been reached, new employees hoping to experience a similar level of growth would need to see the company reach a $199 billion valuation and become what is now commonly referred to as a “hectocorn.” A title that only four privately held companies can currently claim as opposed to the over 1,200 start-ups that can call themselves unicorns.   

This improbability of growth, as well as the high financial cost to employees to exercise their options, are some of the driving factors behind the abandonment of stock options at this stage and the commonplace adoption of RSUs.  

In the fast-paced ecosystem of the start-up industry, unicorn companies are in a perpetual race, not just for innovation or market share but primarily for talent. Talent is the lifeblood of these companies, driving innovation, growth, and long-term sustainability. With multiple unicorns and up-and-coming start-ups vying for the same pool of top-tier professionals, how an equity compensation package is structured will ultimately play a pivotal role in talent acquisition and retention. 

So, while stock options may be a viable choice at the beginning stages when a company's valuation is lower, their appeal dwindles as the company matures and its valuation soars, and listed below are some of the reasons as to why RSUs have become a key weapon in winning the battle for talent. 

Unlike stock options, RSUs are considered " full-value awards." This means they inherently hold value from the moment they are granted. There's no waiting and hoping for the company's stock price to exceed an exercise price. Their immediate tangible value makes RSUs a more predictable and stable form of equity compensation, which is especially enticing for senior-level hires and industry leaders looking for more certainty in their compensation packages when seeking new opportunities.  

With stock options, employees are faced with the potential dilemma of a high exercise price as the company's valuation rises. This can be a significant financial burden, and it adds an element of risk. RSUs sidestep this issue entirely, offering direct ownership without any upfront cost. 

Likewise, RSUs always provide an economic benefit to employees, regardless of the company’s stock price trajectory. A company with a stock value of $.25 per share has no place to go but up. This isn’t the case for a company with a price of $50 per share; the more mature company must consider a possible decline in stock value when determining its compensation strategy. Indeed, many private companies experienced a decline in value as a result of the economic volatility over the past year. By granting RSUs, companies can be assured that employees will realize value from their equity awards, even if their price declines.  

This has implications for the company as well as employees. The company isn’t able to reduce or reverse the expense it recognizes for underwater options (e.g., an option with an exercise price that is higher than the current stock value) even though these options produce no economic benefit to employees. By granting RSUs, companies ensure that the cost incurred for their equity program produces an economic benefit for employees.  

RSUs can be tailored to vest based on time or performance milestones. This allows companies to align equity compensation with long-term objectives, ensuring that the interests of the employees and the company remain intertwined. 

The taxation landscape for RSUs is generally more straightforward than that of stock options. When RSUs vest, they're taxed as regular income based on their market value at that time, offering clarity and predictability for employees. 

As private companies mature and approach an IPO, they may want to align their equity compensation strategy to mirror that of public companies, so that they are better positioned for success after their IPO. Public companies more commonly grant RSUs than stock options: 85% of public company respondents to the NASPP/Deloitte 2021 Equity Incentive Design Survey grant RSUs, while less than half grant stock options.  

The journey from startup to unicorn status is both exhilarating and fraught with challenges. At each stage of this journey, the strategies employed, from innovation to recruitment, need meticulous reevaluation. Among the various factors that set unicorn companies apart is their ability to adapt to changing landscapes, especially in the realm of compensation and employee incentives. 

RSUs and their inherent value, adaptability, and minimized risk position them as a compelling alternative to traditional stock options for mature companies with lofty valuations. By adopting RSUs, unicorns not only showcase their commitment to sharing their success with their workforce, but they also strategically place themselves at a vantage point in the fierce competition for top talent.