Imagine you’re a leader at a late-stage startup. You’ve raised several rounds of financing, but you’re not quite ready for an IPO or exit. The market is a little squishy, so you’re waiting—but morale is in danger of slipping. Long-time employees are wondering if their stock options will be worth what they’d hoped. Newer hires aren’t as excited about their options, because the exercise price is much higher than it used to be. Will they really see much upside?

Many private, venture-backed companies are facing this scenario (or something like it) right now. With timelines to exit much longer than they used to be, startups need new tools to retain and motivate employees for the longer haul.

Many such companies see restricted stock units (RSUs) instead of stock options as part of the solution. It can be a smart move—but only if done at the right time, with a clear sense of the potential pitfalls. We prepared this explainer with help from compensation experts at Sequoia, as well as actual scenarios that have emerged within our portfolio. We’ll walk you through the basics of RSUs: what they are, how they differ from stock options, and what type of companies might offer them. We’ll briefly cover common questions your employees may have. Then we’ll explore some real-world questions company leaders should think through before making a switch.

Let’s start with the basics.

What is an RSU?

A restricted stock unit (RSU) is basically a promise to grant someone a given number of shares in a company at a certain time—or when certain conditions are met. Typically, RSUs are either time-bound, linked to performance, or both. So a new hire’s RSUs might vest in tranches every year for five years. Or a long-time employee might be granted a chunk of RSUs that vest when the company hits a specific revenue milestone.

How is an RSU different from a stock option?

Options give an employee the option to buy a certain number of shares at a set “strike price” at any time. They offer the traditional startup dream: Get in on the ground floor of the next Google/Uber/etc., and when the company goes public, you can buy your options for the pennies they were worth when you started—and then sell them for the millions they’re (in theory) worth now.

RSUs, on the other hand, are simply worth whatever they’re worth when they vest. Unlike options, employees don’t have to pay anything to exercise them—once RSUs vest, they’re freely granted. From the employee perspective, it’s more like being granted equity at a big, established company: less potential for massive upside and overnight wealth, but more predictability.

Why startups make the switch from options to RSUs

RSUs tend to make more sense for companies at a later stage of growth. As your company grows and your valuation climbs, that strike price starts to become more of an issue—later hires see less upside potential might experience more of a scramble to pull together cash if they decide, for whatever reason, they need to exercise their options before an IPO. One portfolio company we spoke with recently explained their strategy: “We made the switch almost four years ago due to rising strike price/convergence.”  Another concurred: “We started to issue [RSUs] a few years ago during IPO readiness, and because strike price was getting quite high.”

Companies with large international operations may also see benefit in switching to RSUs. International taxes are already complicated and costly to manage, so a simple grant of shares at a predetermined time may work better than options for employees living overseas. One of our portfolio companies started issuing RSUs because they have a “huge presence in India, and not having a strike price helps attract talent.”

Eliminating the strike price and (from the employee’s perspective) upfront tax payment involved in exercising options streamlines the offering for employees, too. An RSU can essentially function as a bonus that is easily converted into cash in one step. As one HR leader at a mature portfolio company put it: “We’re still using options for our new-hire and refresh grants, but we introduced RSUs for retention and recognition grants. We wanted a way to differentiate these by offering an equity vehicle that didn’t require the individual to come out of pocket to exercise.”

Why RSUs are becoming more popular now

Over the past few years, we’re seeing more later-stage, larger companies stay private for longer as they wait for a liquidity event. Switching to RSUs makes sense for many of these larger companies because it offers more predictability and stability for employees who joined the company more recently.

RSUs vs. stock options: A comparison chart

Let’s review the key differences between RSUs and stock options:

To sum up, RSUs are a simple grant of shares that vest at a predetermined time and/or when the company hits certain milestones. Once they vest, they’re immediately available as shares, and employees can sell them right away.

Because RSUs tend to be granted by later-stage companies, there’s more predictability. Employees can be fairly confident that shares in an established company will be worth something in five years’ time. And because there’s no cost to exercise, even if the value of the shares dips between the time they’re offered the package and the time the shares vest, it will still probably translate into money in their pocket.

Stock options, by contrast, require the employee to make decisions, usually after talking to a tax professional. They must choose when to exercise the options—and if they don’t sell right away, they may end up paying alternative minimum tax in the year they exercise, and then paying capital gains tax when they eventually sell. Options are most attractive for employees when there’s a significant upside—when the exercise price is significantly lower than the price at which they’re able to sell. From the employee’s perspective, options do confer downside risk—if the company doesn’t succeed, the value of the shares could fall below the exercise price, making them worthless.

The leadership perspective: Downsides to consider

We’ve covered the basics from the employee’s perspective. Now let’s consider the company leadership perspective. Leaders should consider a few points before making the switch to RSUs from options:

• Internal divisions. Whenever you switch to RSUs, you’ll create a division within the company between early employees and later hires. Typically, companies grant fewer shares when they offer RSUs (because they involve less downside risk). So switching to RSUs too soon could create a group of ‘early RSU’ employees who benefit less from the company’s growth than peers who were hired earlier—and potentially even walk away with less cash altogether, because they’ve been granted fewer shares.

SOLUTION: Time the switch right. Wait until you enter that slower-growth stage, and/or until the strike price for options becomes problematic for employees.

• Tax headaches. Options create complexity because employees have to choose when to exercise them, but the lack of choice in RSUs means it’s up to you to structure an equity package to avoid causing unintended problems for employees. Because employees will be taxed when their RSUs vest, if RSUs vest before the company goes public, employees could potentially owe a tax bill on shares they can’t easily sell. This is particularly relevant when the blackout period occurs during the first few months after an initial-public offering and shares are listed. During this period, insiders, including employees, cannot sell their shares.

SOLUTION: This is why companies go for a double-trigger structure for RSUs. If shares don’t vest until X years have passed and the company has gone public, then employees won’t be taxed until they’re easily able to sell their shares to cover the bill.

• Employee confusion. Any kind of switch like this can create uncertainty and confusion for your people. If employees are already familiar with how options work, they may not be as prepared to manage RSUs.

SOLUTION: Make it simple. Offer employee education to make sure people are prepared for the different tax implications of their equity packages. Many companies also offer employees the option to withhold some of their shares when their RSUs vest, to cover the tax bill and make the process as smooth as possible.

• Raised expectations. Employees who do understand the differences between options and RSUs may take the switch to RSUs as a signal that you’re preparing for an IPO. If you’re still some years away from going public, you could be setting them up for disappointment.

SOLUTION: Timing is everything! Make sure you switch at the right time, when you’re prepared to send this signal to your savviest employees. Battery can help portfolio companies pinpoint the precise moment for their company’s trajectory. Contact us to discuss your situation.

Bottom line

If timed right, a switch to RSUs should be beneficial both for a company and its employees. As a company leader, you’re looking for the moment when offering options no longer makes sense from a burn perspective. If you’re finding that the spread between strike price and fair market value has narrowed enough that you have to offer more options to create the same financial value to the employee, it’s time to think about a switch. As an advocate for your employees, aim for the moment when the cost to exercise new options becomes too expensive, or the upside potential of new options levels off. If you choose your moment well, everyone should feel good about the change.