Stock Options vs. RSUs: Understanding Equity Compensation
Stock options and Restricted Stock Units (RSUs) are among the most frequently used forms of equity compensation given by employers to their employees. Both types of compensation enable workers to share in the company’s growth and profitability, making them a desirable addition to most jobs, particularly within startups or companies that are listed on the public stock exchange. Knowing the differences, advantages, and disadvantages of stock options and RSUs is important for workers who need to get the best out of these compensation methods. In this blog, we will outline the basics of stock options and RSUs and contrast the two extensively.
1. What are Stock Options?
1.1 Definition
Stock options provide employees with the right, but not the requirement, to buy company stock at a fixed price (the exercise price or strike price) following a given vesting period.
1.2 How Stock Options Work
Employees are given stock options on the understanding that they can acquire the company’s stock at the strike price following the vesting of the options.
If the value of the company’s stock exceeds the strike price, the workers can purchase the stock at the lower strike price and then sell it for the market price and make money off the difference.
1.3 Stock Option Types
- Incentive Stock Options (ISOs): They are usually earmarked for workers and have a preferable tax advantage. Workers are allowed to delay tax payments until when they dispose of the stock.
- Non-Qualified Stock Options (NSOs): These are more widely utilized and do not provide the same tax advantages as ISOs. Taxes are owed when the options are exercised.
1.4 Vesting Schedule
Stock options are usually subject to a vesting schedule, i.e., employees have to stay with the company for a specified time before they can exercise the options.
A common vesting plan may be 4 years with a 1-year cliff, which means that employees have to remain for one year before vesting of any options, and vesting of the remaining options over the subsequent three years.
2. What are RSUs (Restricted Stock Units)?
2.1 Definition
RSUs are an equity compensation in which employees receive company stock subject to vesting requirements. RSUs differ from stock options in that they are actual stock, and employees do not need to buy them.
2.2 How RSUs Work
RSUs usually come with a vesting schedule. The employee gets company shares once the RSUs have vested. In case the stock price of the company has risen, the value of the RSUs will also have grown, making it profitable for the employee.
The employee does not need to buy the stock but will owe tax on the value of the RSUs at vesting.
2.3 Vesting Schedule
Like stock options, RSUs have a vesting period, which means the employees have to remain with the company for some time before they can get the full value of the RSUs.
The vesting may be time-based, performance-based, or a combination of both.
2.4 Tax Implications
RSUs are taxed as ordinary income upon vesting, i.e., the employee has to pay income tax on the fair market value of the shares at vesting. This can result in a huge tax bill if the stock price has appreciated significantly.
3. Comparing Stock Options and RSUs
3.1 Ownership vs. Purchase Rights
- Stock Options: Stock options allow employees the opportunity to purchase company stock at a predetermined price, and the decision of whether or not to exercise the option depends on how well the company’s stock has done.
- RSUs: RSUs, as opposed to the above, are actual shares in the company which are given to employees upon vesting. When the RSUs vest, employees own the stock automatically, not having to buy it.
3.2 Potential for Profit
- Stock Options: Profit opportunity with stock options is based on the difference between the market price of the stock and the strike price. If the stock price goes over the strike price, then employees can gain profit. But if the stock price remains below the strike price, then the options are worth nothing.
- RSUs: RSUs provide a simpler route to profit since employees are given company stock when the RSUs vest, irrespective of the market price of the stock. They are taxed on the value of the stock at vesting, which may be a disadvantage if the stock price has risen substantially.
3.3 Taxation
- Stock Options: The taxability of stock options is based on whether they are ISOs or NSOs. ISOs can provide beneficial tax treatment, but NSOs are taxed upon exercise, at regular income tax rates.
- RSUs: RSUs are treated as ordinary income when they vest, depending on the fair market value of the stock. Employees can also be required to pay capital gains tax when selling the stock, depending on the period they keep it after vesting.
3.4 Vesting and Risk
- Stock Options: Stock options pose some risk to employees, as the options could lose their value if the stock price does not move above the strike price. Stock options, however, can provide greater upside if the stock price goes up significantly.
- RSUs: RSUs are less risky because employees receive the stock automatically when it vests. The drawback is that RSUs can create a huge tax bill when they vest, particularly if the stock price has risen exponentially.
4. Advantages and Disadvantages of Stock Options
4.1 Advantages
- High returns if the stock price of the company increases substantially.
- Employees can purchase stock at a lower strike price than the prevailing market price.
- Can encourage workers to work towards the success of the company, as they understand their endeavors might make the share price go up.
4.2 Cons
- Options can expire worthless if the share price does not rise above the exercise price.
- Taxes on options are paid at the time the options are exercised regardless of whether or not shares are sold.
- Staff may not gain from options if the company’s shares stay still or fall.
5. Advantages and Disadvantages of RSUs
5.1 Advantages
- Less risk than stock options because employees receive the stock automatically when the RSUs vest.
- Employees don’t have to buy the stock, and there’s no danger of the RSUs depreciating.
- RSUs can be an effective retention tool because employees must remain with the company in order to fully vest.
5.2 Cons
- Taxable as ordinary income when the RSUs vest, which can cause a huge tax burden.
- Employees are subject to taxation whether they sell or not upon vesting.
- There is no hope of profit that exceeds the value of the stock at the date of vesting.
6. Which is better: Stock Options or RSUs?
The decision between stock options and RSUs will hinge on the person’s objectives, risk acceptance, and performance of the company’s stock. Stock options will be more attractive to individuals who are ready to assume greater risk with the possibility of higher rewards if the company’s stock appreciates considerably. The RSUs have more certain rewards and less risk and would therefore be preferable for employees who seek to have company stock guaranteed in the long term.
In the end, both stock options and RSUs are useful employee compensation tools, and knowing the distinctions between them can assist you in making the best choices about your financial destiny.