Double-trigger vesting helps fuel unicorn growth
This article previously appeared in the July 2019 issue of HRIS & Payroll Excellence by HR.com.
Several years before its initial public offering (IPO) in 2012, Facebook had a big recruiting and retention problem. The private company was already valued well in excess of $1 billion, and any stock options it offered might have been viewed as unattractive due to a perception that there was little upside left—the value of the company had already increased so much.
In addition to their recruiting and retention issue, they had an SEC problem. SEC rules had been in place for decades that required private companies to provide financial reporting similar to that required by public companies, once the number of shareholders exceeded 500. The 500-shareholder threshold was an important issue for fast-growing tech companies with large numbers of employees holding restricted stock and exercising stock options. (In 2012, the threshold was increased to 2,000 with the JOBS Act legislation.)
Facebook solved their recruiting and SEC reporting problem by switching to restricted stock units (RSUs) instead of stock options and restricted stock as the preferred form of equity compensation.
Restricted stock units represent a pledge by a company to transfer shares of its stock to an employee after certain conditions have been met, a process known as “vesting.” The most common condition is a time-based service requirement in which employees receive shares only after they’ve worked for the company for a required amount of time. RSUs typically “vest” either monthly or quarterly for three to five years, with a one-year “cliff,” which means the first twelve months or four quarters of vesting complete all at once at the end of the first year. For example, an employee with an RSU that vests monthly for four years with a one-year cliff will receive one-fourth of the total shares at the end of one year and 1/48 of the total shares each month thereafter.
Traditionally, this method of RSU compensation was only used in publicly traded technology companies. But in a field known for innovation, it’s no surprise pre-IPO tech giants are innovating compensation too.
Unicorns and Double Triggers
Recently, other large private tech companies with valuations over $1 billion—known as unicorns because they are vanishingly rare—that expect to go public within a few years have used RSUs. This creative form of compensation helps these companies attract top technical talent, and incent and retain employees, in ultra-competitive job markets.
But RSUs at private companies pose a problem that doesn’t exist at public companies. The main culprit: taxes.
An employee is taxed on the market value of vested RSU shares when the shares are delivered; those RSU shares are taxed as ordinary income and reported in the employee’s pay stub and on Form W-2. In publicly traded companies, even a large tax obligation from vested RSUs poses little problem, because the employee can sell some of their shares to pay the income tax owed.
However, employees of private companies are not able to sell any of their shares to pay income tax. Since private companies have not yet had an IPO, their stock is still illiquid. This situation could put employees in an incredible bind and force them to come up with personal cash to pay income tax on stock received from vested RSUs.
Facebook solved this problem ahead of their IPO in 2012 by adding a second condition to its RSUs in order to complete vesting. In addition to the standard time-based service requirement (e.g., four-year vest with one-year cliff), RSUs would not complete vesting until a second liquidity condition was met. The liquidity condition was defined as “a change of control transaction or six months following the effective date of our initial public offering.” In other words, if the company was acquired or went public.
This second condition has come to be known as a “double trigger.” The first condition alone doesn’t trigger vesting; the second condition, the double trigger, must be satisfied as well. RSUs with only time-based service vesting are known as single-trigger RSUs.
Double-trigger vesting solved a big problem for employees: how to come up with cash to pay taxes. In the Facebook case, the liquidity requirement was satisfied six months after the company went public, which coincided with the end of the six-month lock-up period. As is typical with IPOs, employees were not allowed to sell their shares until six months after the IPO. Because the second vesting condition was not met until six months after the IPO, no income tax was owed until then on shares that had satisfied the time requirement. Because employees were allowed to sell their shares six months after the IPO, they could raise cash to pay taxes by selling shares at that time.
Double-trigger vesting was a major innovation to RSUs. Since Facebook’s IPO, other private tech giants—both unicorns and non-unicorns—have followed suit. Dropbox, Lyft, Pinterest, Uber, and others disclosed double-trigger RSU arrangements in SEC filings prior to their IPOs.
In the Facebook RSU structure, one potential disadvantage to employees was that if the stock price continued to rise during the six-month lock-up period that coincided with the second trigger, employees would pay more tax than if the second vesting condition was satisfied as of the date of the IPO. Remember: tax is owed when the second condition is met, and earlier is better if the stock price is going up. Employees don’t have a say in when they incur tax liability with RSUs.
Dropbox, Lyft, Pinterest, Uber, and others use double-trigger vesting with the date of the IPO (or being acquired) as the second condition of vesting. With double trigger at IPO date, employees incur tax liability on the IPO date for shares that have met the service-based vesting requirement. However, in these cases, employees were still bound by a 180-day lock-up period during which they couldn’t sell shares, even to raise cash to pay income tax.
To get around this new problem, these companies are innovating again by withholding income tax in the form of stock. The companies deliver vested shares to employees but hold back a certain number of shares to use to pay income tax. Since the US Treasury doesn’t accept stock as payment for income taxes and payment deadlines are short, these companies use cash raised in their IPOs to pay the tax, which can create substantial financial and administrative burden.
From the employees’ perspective, much of their income tax is paid on RSU income, and they begin the one-year holding period required for favorable long-term capital gains tax treatment on their remaining shares. They are still subject to market risk because they cannot sell the remainder of the shares until the end of the six-month lock-up period. That may be less of a problem than it appears at first glance because most employees will diversify their company stock holdings gradually over time after the IPO, and will probably hold at least some of the vested RSU shares for one year (six months past the lock-up period) to get long-term capital gains treatment. The shares they hold would be subject to market risk anyway.
Double-trigger vesting also creates a new problem that public company RSU holders don’t face. For employees who have been with the company for some time before an IPO, they have likely met most or all of the time-based service vesting requirement. That means that when the second condition is met at IPO, direct listing, or acquisition, their shares will be taxable all at once (we’ll look at the unique case of direct listing shortly).
Even modest amounts of share-vesting income added to their regular salary and bonus can push employees into the highest tax brackets. And as with RSU vesting in publicly traded companies, employers are required to withhold income tax at the statutory supplemental withholding rates, which often do not cover the employee’s full tax liability. Employees will need to have tax projections prepared to ensure that enough tax is withheld, or make estimated tax payments, to avoid federal and state income tax under-withholding penalties.
Still, with all the potential tax downsides, there are major upsides for companies in recruitment and retention, and employees in incentives and compensation.
More Advantages: Direct Listing vs IPO
In June of 2019, Slack became the second large private tech company to offer its shares to the public in a “direct listing” without going through the traditional IPO process. In a direct listing, existing shareholders offer their shares directly to the public instead of going through intermediaries.
During the direct listing process, the company creates no new shares to sell to the public and does not raise new capital. From the company’s perspective, the primary purpose of a direct listing is to provide liquidity to its existing shareholders and employees, and potentially use its stock for acquisitions. Because there are no intermediaries involved, the stock price may be more volatile than if the company used the traditional IPO process.
Slack also offered RSUs with double-trigger vesting to its employees. With the direct listing, employees are able to sell their stock without waiting for a lock-up period to expire, which allows them to immediately sell shares to pay taxes; they can also diversify and reduce exposure to risk of the company’s price falling. However, many employees will still probably hold at least some or most of their shares for one year to get long-term capital gains treatment on those future sales. Using the direct listing approach to going public is another tech sector innovation that may prove valuable to employees of Slack and other companies.
By creating and evolving double-trigger vesting of restricted stock units, large, fast-growing private tech companies are innovating to incent and retain talented teams. What compensation innovations will the future hold? Watch the booming tech industry to find out.