The Case for Private Companies to Use Restricted Token Units

Key Points

There are established benefits for companies from awarding employees with Restricted Stock Units (RSUs) in preference to Restricted Stock Awards, in seeking to attract, retain and motivate them, because RSUs both impose a lower tax burden, and they avoid the need for employees to finance the acquisition of the underlying shares, which many find that they cannot afford to do.

With Restricted Token Units (RTUs), there are further benefits for employees, especially in private companies, including providing them with liquidity opportunities to cash-in prior to an IPO, which unfortunately for many is becoming an increasingly distant prospect, with the current time to IPO being estimated at 11 years. RTUs also offer benefits to companies by reducing the administrative burden of traditional stock options, avoiding immediate dilution of existing equity, and potentially reducing the costs of accessing liquidity.

The crucial 'if' for RTUs is that they can work, especially if they are to be traded, but only if there’s a conducive regulatory regime. Fortunately, this has now started to happen in certain jurisdictions, with others sure to follow.

What Are RTUs?

RTUs are the blockchain’s answer to RSUs, with tokens instead of stocks being issued upon a liquidity event. As with RSUs, RTUs are treated as securities.

Before getting into RTUs, it may be helpful to do a quick reprise of RSUs. This is compensation issued by a company to an employee in the form of company shares in line with an attached vesting schedule, once certain conditions specified at the outset are met. These conditions usually involve achieving required performance milestones, and/or remaining in the employ of the company for a minimum duration. Whilst RSUs give employees an interest in the company’s equity, they have no tangible value until they vest, at which point they are assigned a fair market value and are usually treated as income.

Turning then to RTUs, consider a company wanting to allocate 10% of its common stock, equivalent to 1,000,000 shares, for an incentive stock option (ISO) for its employees. It places these authorised but unissued shares into a stock option pool. It then creates 1,000,000 tokens on the blockchain, with one token being equivalent to one share, which it correspondingly places into a token option pool. From this token option pool, the company can then notionally allocate token options, with the usual attaching RSU conditions to employees as RTUs.

When it grants RTUs to an employee, the company is promising the employee a specified number of tokens in the future. This promise is dependent upon each of the requirements attached to the RTUs being met when they come to vest. Until the RTUs vest, the employee is not a legal owner of the underlying shares and, importantly, is not, therefore, subject to tax.

The company also benefits from the same tax and legal advantages as using RSUs. If the conditions for vesting are not met, the company can rescind the promise to the employee and withdraw the RTUs.

Attractions of RSUs over Other Stock Awards

Compared to other types of stock awards, RSUs are popular for the following reasons, which are equally applicable to RTUs:

• The timeline is clearly set out as part of the award, including a schedule setting out any phased vesting;
• They are easy to value (= number of shares included in the RSU x share price);
• RSUs' biggest attraction over other stock options is that taxes are not payable on the award of the RTU, but only at its vesting, usually calculated as if the award is ordinary income, and also usually automatically deducted by the company from the shares vested;
• RSUs also provide an opportunity to defer taxes beyond vesting, for example by including within the RSU a condition for payment at a later event or date;
• Unlike stock options, RSUs always have a value whilst the company is trading, and they do not require complex decision-making evaluating trade-offs (for example, whether to make an election for tax relief);
• Another big attraction that RSUs have over stock options is that they do not require the employee to have to fund the purchase of the options before being able to trade the underlying shares, as many employees find it difficult to raise the necessary funds and, even if they do, the selling costs mean they must give up some of the benefits;
• Finally, RSUs can also avoid inadvertent tax being triggered when an employee becomes eligible to take retirement, rather than when they actually retire. On the flip side, employees will not receive any dividends and are unlikely to have voting rights until the shares have vested.

Attractions of RTUs over RSUs for Private Companies

Despite the attractiveness of RSUs as a stock reward, there are several respects in which they still fall short, especially for private companies. Fortunately, many of these shortcomings can be addressed by RTUs.

Employee Perspective

The biggest turn-off for private company employees is that RSUs are highly illiquid. Not only do they usually include a double-trigger, so that they only vest at the later of a minimum duration and a liquidity event, but even when the shares are awarded, they are not easy to trade and then only on the private secondary market. For most employees, accessing the secondary market is not an option because of minimum deal sizes, high costs of transactions and the deep discount a buyer is likely to apply.

One of the main reasons why RSUs usually have a double-trigger, rather than a single-trigger, is because companies tend to want to defer the point at which employees become liable to paying tax on the shares they will receive. This is, in turn, because the shares will be illiquid, and employees often struggle to meet the taxes due. This is in stark contrast to publicly listed shares, as companies can readily sell enough of the shares to cover employees’ tax so that employees simply receive net-of-tax proceeds.

Thus, RSUs can fail to fulfil their purpose of attracting, motivating and retaining employees in private companies.

This is where RTUs can have a big advantage over RSUs. Because RTUs are represented by tokens on the blockchain, employees can be given the option to sell their RTUs before they vest, provided this does not breach the RTUs’ conditions. This means that employees can, if needed, sell enough of their RTUs to cover the tax liability that will arise when they receive the underlying shares. This would also allow companies to replace a distant double-trigger with a nearer-term single-trigger. Together, these features of RTUs are likely to result in employees regarding them as more valuable and incentivising than RSUs.

Private Company Perspective

From the company’s perspective, by IPO with traditional stock options, employee equity is more diluted and subordinated, making it increasingly less effective as an incentivisation tool. However, from this perspective, using RTUs is 'non-dilutive' in nature because tokens are not company shares and, therefore, issuance does not immediately affect or dilute the stake of existing shareholders.

Also as RTUs are implemented via a 'smart contract' on the blockchain, with all the attaching conditions coded into the contract, the ongoing administration of the RTUs will be less onerous for the company compared to traditional stock options, as many of the features will be automated.

Probably most importantly, by tokenizing stock options on the blockchain, the company creates a potential path to raising its own capital and accessing liquidity without going through traditional secondary markets, which are expensive and time consuming to access. For example, there are already companies building capitalisation table management tools intended to simplify the process and reduce the costs of managing private equity, by leveraging the intrinsic features of the blockchain. This is a market, whilst still being established, is developing rapidly.

Valuing RTUs

One of the questions companies will have is how to assess the value of an RTU. The easiest and most common way is to use a current valuation method. Here, the company simply uses the share price from the most recently raised capital.

RTU Mechanics

Let’s stay with the example mentioned above of a company wanting to allocate 10% of its common stock, equivalent to 1,000,000 shares, for an incentive stock option (ISO) for its employees, placing these authorised but unissued shares into a stock option pool, and then creating 1,000,000 tokens on the blockchain, with one token being equivalent to one share, which it correspondingly places into a token option pool.

The company then sets up several 'whitelists', each with its own criteria so that at any time it can track the RTUs by an employee, including the status of the attaching conditions; for example:

• Employees with unvested options
• Employees with vested options
• Employees with unvested stock
• Employees with vested stock
• Authorised third parties allowed to transact vested stock

These whitelists will ensure that only permitted transactions, and only by those authorised to do so, can take place, and that the necessary regulatory requirements, such as KYC, are met. As with the capitalisation tables mentioned above, there are companies specialising in carrying out these various regulatory requirements on the blockchain.

For them to provide the holder with the option of liquidity, the RTUs must be granted on the basis that the holder can redeem them for equity options, whoever the holder. This information can potentially be embedded as metadata within the token. Further, given that private companies have the right to approve holders of their equity, this right can be embedded within the token.

The ideal token standard is likely to be ERC-1155, rather than ERC-20 or ERC-721, as this would allow the fungibility of a select asset class versus others; meaning that the company could have different RTU classes, with multiple amounts within one RTU class.

Whilst not seeking to trivialise the process, companies can work with a manager of tokenised equity to set up a stock award program based on RTUs relatively straightforwardly:

1. Engage a developer or sysadmin familiar with blockchain
2. Code the RTU conditions into a smart contract, and deploy it to the network
3. Upload the customised RTUs terms and conditions document to IPFS
4. Deploy and configure RTU employee interface, which could be just a simple web application without any backend components
5. The smart contract is ready for RTUs to be issued!

Implementation Considerations

Given that RTUs are treated as securities, it is important to consider the following for each jurisdiction involved:

• Laws applicable to securities,
• Taxation treatment,
• Compliance with labour and employment laws,
• Structuring of vesting, and attaching conditions and
• Accounting treatment.

Regulations

As RTUs would be regarded as securities in most jurisdictions, they need to be recognized in their virtual form under the laws of the jurisdiction in which they are issued, but this does not usually create issues unless they are to be traded. There are additional challenges if they are to be traded across jurisdictions, as they also need to be recognized in each jurisdiction involved.

Countries with the most accommodative regulatory regimes for issuing and trading security tokens such as RTUs include Israel, Luxembourg and Switzerland. But, the list is growing!

Author & Acknowledgements

Author

Harpal Karlcut is currently undertaking a Masters in Blockchain & Distributed Ledger Technologies at the University of Malta, as part of an undertaking on a project for Simetria, including investigating blockchain-based opportunities.

Acknowledgements

Ziv Keinan, the CEO of Simetria, spotted the understated benefit to private companies of making use of Restricted Token Units in preference to Restricted Share Units. He also provided key feedback in ensuring that the employees’ perspective was properly captured in this paper.