Podcasts

Seth Gottlieb: 

Hello and welcome to The LathamTECH Podcast, where we survey the latest trends emerging from the world of tech and explore their impacts on your company, both the opportunities and the risks. I'm Seth Gottlieb, Co-Chair of Latham’s Tech Industry Group, and with me today is my colleague and partner, Ashley Wagner. Hi, Ashley.

Ashley Wagner: 

Hey, Seth. Happy to be here.

Seth Gottlieb: 

It's great to have you. In this episode, we're discussing RSUs in secondary offerings, a trend that's reshaping employee equity management across the tech industry. Ashley advises on executive compensation and employee benefits. She provides companies with insight into balancing talent retention with legal and financial considerations. So let's kick things off. So, Ashley, can you just explain the concept of what an RSU is and what a double trigger RSU is?

Ashley Wagner: 

Sure, Seth. So they are the right to receive shares in the future on vesting. They don't have an exercise price. They don't have a purchase price like regular options, but they do become taxable as soon as they vest. To avoid a taxable event for most private companies, we issue what's called double trigger RSUs. So these have two vesting requirements. The first is that traditional time base service schedule. The second one is a liquidity event trigger. This doesn’t require continued service, but typically needs to be achieved within a specified period of time.

Seth Gottlieb: 

So why do you think RSUs have emerged, and we're seeing this with just increasing popularity, particularly I think, in the last five years, and what are the implications for private companies?

Ashley Wagner: 

So I think we're having a lot of high value companies staying private longer, especially given recent market conditions. And so RSUs are a helpful tool for those employees when the exercise price gets really high and there's no longer, kind of, a retention incentive to those employees. And so RSUs are a full value award, again we talked about there's no purchase price. And so companies can issue these RSUs without worrying about fluctuations in stock price or any kind of expiring period similar to options. 

Seth Gottlieb: 

I've also had it come up where the RSUs attract a certain kind of talent. If a company's growing, the talent that they're trying to hire might expect RSUs because they're used to working at a public company, and now coming to a private company, that might be another consideration. Would you, do you see that too?

Ashley Wagner: 

Totally, I agree. And like a bunch of, you know, the late stage hot companies, you know, from long ago with the kind of Metas and Uber, they all started this. And so a lot of companies are expecting if they're late stage and they're high profile, their employees that they're attracting are going to be, you know, expecting these double trigger RSUs.

Seth Gottlieb: 

And then, you know, getting into our topic, they're probably going to expect some secondary as well. So let's talk about that a little bit. I mean it seems like I'm having this conversation almost every day. There's stockholder liquidity transactions, whether in connection with a financing or elsewhere. And many of those companies are later stage with RSUs outstanding. And sometimes those have been outstanding for several years. What are the implications if a tech company wants those RSU holders to participate in a liquidity event or secondary transaction?

Ashley Wagner: 

Yeah, so a lot of employees are looking for liquidity before the final liquidity event of a change of control IPO, because like you said, they've been holding on to this equity for a while, even a couple of years. A final liquidity event, maybe a couple more years or even longer down the road. And so they're saying, you know, is this equity worth anything? And so I think, you know, having these secondary opportunities for employees really shows tangible value of their equity and can keep them in their seats far longer. And this includes allowing RSUs to actually participate in the secondaries. But, you know, there's various considerations you have to have around the structure. If you're going to have those RSUs participate in a secondary.

Seth Gottlieb: 

So how would that work? What would those considerations be and how would you structure that?

Ashley Wagner: 

It's a very gray area in the tax code. So the IRS has never actually opined on RSU participation in secondaries. But you've got kind of two main concerns when you're thinking about RSUs participating. The first one is does your liquidity event trigger for all your RSUs still constitute a substantial risk of forfeiture? Your second one is how are you going to deal with the taxes for someone who's been allowed to participate in a secondary, whether or not they sell the shares? And so those are kind of your two main considerations you're trying to plan around if you're going to allow your RSUs to participate in the secondary.

Seth Gottlieb: 

So what's the substantial risk of forfeiture and how does that apply?

Ashley Wagner: 

Yeah. So, like we were talking about with that liquidity event trigger, it's got to constitute a substantial risk of forfeiture in order to delay your tax event. And so when we're issuing RSUs, we really want that second trigger to still constitute a substantial risk of forfeiture. The more we waive that, the more there's some concern that that could potentially result in that substantial risk of forfeiture no longer constituting that, because you're waving it periodically. And so the question is, you know, is a waiver of that liquidity event considered a waiver of the substantial risk of forfeiture?

Seth Gottlieb: 

Okay. And then what are the kind of pros and cons of waiving that substantial risk of forfeiture?

Ashley Wagner: 

So when you allow RSUs to participate in a secondary, typically you waive the liquidity event prong for a set percentage of your double trigger RSUs. You then net settle them. Net settlement basically means that you're reducing the number of shares they receive in order to cover any tax withholdings. And then the company uses its own cash to remit to the IRS those tax holdings. So first, the company needs to have the cash. If the company doesn’t have the cash, you know, there's other problems we need to go into, because otherwise you're asking employees to come up with the cash on hand. Now, once you've net settled, you then let people sell those shares into the secondary. 

You know, the market's been changing constantly on this. So I would say five years ago the general rule of thumb was RSUs could not participate at all in secondaries. That's now evolved to where everyone is very comfortable. They can participate at least once in a secondary using this kind of net settlement concept, where we then sell the shares. Now, any more than that, you start getting more into a gray area. And so that's where again, the cons start coming, because we have these companies who are doing pretty consistent secondaries and we're trying to figure out, you know, how do we let them continue to get value from their RSUs and let them continue to participate. And it kind of comes down to various considerations where the company may want to think about structuring their RSUs.

Seth Gottlieb: 

Okay. What are some ideas that you've seen or some creative solutions to structuring the RSUs?

Ashley Wagner: 

So there's various I think, considerations you can have. So the first one is, you know, when we're doing that we're waiving that liquidity event prong, where we talked about, we're waiving that, we're net settling those RSUs. Consider what percentage you want to waive it for. Is it a broader percentage where, you know, those RSUs are just going to start net settling in the future, and then you let those participate for any future offering? You know, we've a lot of late stage companies who do that, where they just don't have that second prong for a large portion of theirs. You can also require continued service on your liquidity event prong. And where, you know, you have to stay employed through a liquidity event for some portion of your RSUs, because then you can accelerate those as many times as you want for your liquidity event. 

So there's various kinds of structuring alternatives. I'd also say, you know, if you've got a large outside of the US population, these concerns are basically non-existent. So Section 409A is a US-specific concept. Like outside the US, they just don't have the same considerations. So, you know, we have a lot more flexibility, especially for these large companies who have a lot of non-US presence. And so we can use that as kind of the ability to let them participate. And then for the US holders, we can structure the awards in certain ways depending on how the company wants to handle it. So that those RSUs, we don't have to waive a liquidity event trigger multiple times. But a lot of it is also probably about risk tolerance, like I'm sure you've seen.

Seth Gottlieb: 

Yeah, I love 409A. I mean it's a gift that keeps giving.

Ashley Wagner: 

Who doesn't?

Seth Gottlieb: 

So can companies pick and choose the RSUs that they want to have the liquidity event accelerated for?

Ashley Wagner: 

To a certain extent, yes. So you do need an objectively determinable criteria. You know, kind of like the tender offer rules, which I usually end up deferring to you guys on. But as long as it's not discriminatory. And again, if you've got a non-US presence, you need to be especially careful about that discriminatory basis. But as long as it's not discriminatory, you can pick and choose how many, whether it's 10%, whether it's 5%, whether it's 100%, or somewhere in between and what makes sense. I would say, you know, if you're going to waive it, and let's say you have 20% participating in the secondary, consider if you want to waive it for more. If you're going to do this next year, you might want to waive it for a larger portion now, so you don't have to take any risk on waiving it in the future.

Seth Gottlieb: 

Okay. Got it. And you mentioned this earlier. So what happens when you waive it, you net settle, I assume you do that at withholding rates, right?

Ashley Wagner: 

Yep.

Seth Gottlieb: 

So do employees then have a taxable that they have to worry about in the future?

Ashley Wagner: 

So they may. And so you want to be really careful about your taxes. So the general rule of thumb is you withhold at statutory minimum. That's what accounting guidance says. Many people are in higher tax brackets. And so they will end up owing additional tax. And if the company is not careful in its withholding rates, those people may have what we call a dry tax, where they're taking the tax hit without actually receiving any compensation to pay that tax. And so especially if they're not selling in the secondary and they're not receiving that cash, you want to be very careful, you know, at the rate you're withholding. And that's where you really consult with your legal counsel and kind of go through your employee base to see what makes the most sense on your withholding rates and how that's going to work.

Seth Gottlieb: 

Yeah. So it's not something that you just wake up one morning and decide to do. There's a little bit of planning that goes into this. So, you know, given this limitation, I mean, I'm not, I assume you're not seeing RSUs participate in one-off secondary transactions. It's usually kind of a larger sort of organized tender offer.

Ashley Wagner: 

Agreed. Yeah. It's definitely not the same as stock options and especially shares where we're seeing these one-off secondary sales. This is usually a large scale tender offer that's involving a lot of shares with the company. And part of it is it helps our justification of waiving the liquidity event trigger. So one of the requirements to have that substantial risk of forfeiture we keep talking about is that it constitutes the reason of the compensation. So it's liquidity. It’s the whole reason of the compensation of these RSUs. And if we're waiving it as part of a liquidity program for the company, that gives us a better argument under 409A as to why we're waiving it. Because just like the end result of an IPO, or a change of control, this is more liquidity for the company. So it's back to the reason of the compensation.

Seth Gottlieb: 

Got it. But then, you know, doing it more than once, there's, like you said before, there's really no substantial risk of forfeiture, or potentially less.

Ashley Wagner: 

Potentially. You still get into a very gray area. Like the IRS has never ruled one way or the other on this. So we just don't know where it's going to be. And it's kind of a constantly evolving landscape, which is, again, why you really need to consult with your legal counsel.

Seth Gottlieb: 

So stepping back, you know, what would you say are the best practices for structuring, you know, RSUs if a company intends to have, you know, liquidity events in the future? So if I'm starting fresh, maybe I'm 3 to 5 years from an IPO or an exit, and I want to do an RSU program, how would you think about it holistically if I want to have some flexibility for liquidity?

Ashley Wagner: 

So I think it's really taking a step back and seeing how long you guys are anticipating staying private. You know, some companies, we’re looking at upwards of ten years. That's helpful to know. Some companies are more like, nah it's probably three years. So how long do you guys, are you guys looking at before your final liquidity event? And then from there you want to see how often do we want to do our secondaries. Is this going to be like one bite of the apple, two bites of the apple? Or is this going to be more of a yearly thing? If it's going to be a yearly thing, you definitely want to start thinking about how we structure our RSUs from the beginning, as a true double trigger RSU may not be the best approach, given if, especially if you're employee base is mostly in the US. So, you know, it may make sense to do a hybrid of things, whether that's, you know, like some RSUs that don't have that second liquidity event trigger. 

And so you just keep net settling them. And that's especially helpful if the company's got some cash on hand to deal with the taxes. And that way you can just sell those shares in the secondaries you want to. You know, that may mean having a continued service requirement through the liquidity event. So there's various ways, but really be thoughtful instead of just going forward with a traditional double trigger like I see most companies do, where they're just like, of course it's double trigger. Like that's what we do.

Seth Gottlieb: 

Right.

Ashley Wagner: 

Like that doesn't always make sense. And so I think finding a balance between those two, it may be, you know, like half traditional double trigger and then half something else, depending on the needs of the company.

Seth Gottlieb: 

Got it. Got it, that's great. So what do you feel is the future viability of RSU participation in these interim liquidity events, you know? I mean it's mostly the tech industry but, so how do you feel these will play out in the future?

Ashley Wagner: 

So I think the landscape is going to keep evolving. Like we've talked about before, four or five years ago, we were telling people you cannot do a single tender offer with RSUs. We were like, it is not viable. And then we started doing them. And like some of the big late stage companies started doing them and everyone kind of followed suit. And I think given, especially market conditions changing, we're going to see that change again. And we're going to see more pressure on how we structure these RSUs, so that they can have more participation liquidity events and really what, how much risk we want to take on with that substantial risk of forfeiture prong.

Seth Gottlieb: 

Yeah, I mean, the IPO market has been six months away from opening for the last four years.

Ashley Wagner: 

Yeah.

Seth Gottlieb: 

So we’ll see what happens.

Ashley Wagner: 

Yeah, we've been saying that forever. So I think, you know, companies are trying to come up with creative solutions for that.

Seth Gottlieb: 

Yeah, that's great. And so in closing, you know, what key points should companies keep top of mind when it comes to RSUs?

Ashley Wagner: 

So I think they need to think about the right timing for it. So RSUs are not always right for every company. Think about, you know, where your exercise price is, where your fair market value is, how far off you are from liquidity. And then if RSUs are the right mode, how often are you guys looking to provide interim liquidity to your employees? If it's often, think about alternative structures of your RSUs. And then think about your employee base. If you've got a huge non-US presence and a small US presence, it may make sense to, you know, structure in a way that makes sense for non-US folks. But if you've got a huge US presence, you know, be creative in the structuring from the beginning, because it makes it much more flexible going forward.

Seth Gottlieb: 

Ashley, this was great. Thank you so much. I found it really helpful and hopefully our listeners found it helpful as well.

Ashley Wagner: 

Yeah, no, of course. Always happy to join.

Seth Gottlieb: 

And thank you for listening to this episode of The LathamTECH Podcast. You can subscribe and watch or listen to new and archived episodes of Latham's podcasts on lw.com, YouTube, Apple Podcasts, Spotify, or wherever you get your podcasts. If you'd like more information about the topics in this podcast, please email us from links located in the show description. We hope you'll join us again next time.