Considering a career change or have multiple offers in hand? How do you compare equity compensation? Equity compensation can be a catalyst to growing your net worth. Putting a true dollar value on equity compensation is tough when you’re looking at a private company. When the company is publicly traded though, you can look at the latest stock price and know how much the equity grant is currently worth. However, it’s tough to know how much the equity comp will be worth when it vests. When evaluating different equity compensation at publicly traded companies, which is better stock options or RSUs? In this blog post, we’ll explore the pros and cons of stock options and RSUs to help you determine which is the best choice for you.
What are Stock Options?
Stock options are the right to buy a specific number of shares of company stock at a pre-set price following a vesting period. If your pre-set price is $10 and the stock is currently at $50 you pay $10/ share. This is known as the exercise or strike price. When you hit the first vesting period you can exercise your stock options. After you hit that vesting period, you have the right to purchase company stock at that predetermined price whenever you want. It can be that same day, it can be 2 years later – the choice is yours.
To motivate employees to work hard and drive the stock price up a company might grant a large number of options that are significantly below the current market price. Combined with your flexibility to sell any time after they vest, you may have the ability to purchase shares significantly below the current market value. Conversely, if the stock price does not go up significantly, you may not be able to benefit from the equity compensation at up. The stock price could even decline to the point where your equity compensation ends up worthless.
What are Restricted Stock Options (RSUs)?
Restricted Stock Units, or RSUs, are a form of compensation offered by employers to employees. They are company shares that are restricted, meaning that you can’t sell them right away. Instead, you will be given shares that vest over time. When you accept RSUs, they will come with a vesting schedule. Often, you’ll see vesting schedules that span 3 or 4 years. This schedule will show how many shares will vest on which dates. Typically, there will be one day per year and each of those days will be a year apart. On that date you are given those shares at the price of the stock that day. They have no tangible value until the vesting date. If you leave the company before the vesting date that means you walk away from this future compensation.
How Are Stock Options and RSUs Different?
Stock Options and RSUs Redemption
Stock options and RSUs can both have similar vesting schedules. The vesting schedule will depend on what the company offers. Usually, equity compensation is a way to encourage employees to stay at the company. As a result, you’ll often see vesting schedules that span a few years. You may get 1/3 of the equity grant at the end of year 1, 1/3 at the end of year 2 and the last 1/3 at the end of year 3. If you leave the company before your RSUs or stock options vest, you will forfeit the unvested shares.
While they both have vesting schedules, what happens upon vesting is different. When your options vest, nothing happens unless you decide to exercise your option to buy. If you exercise your option to buy, you can initiate an exercise-and-hold transaction (cash for stock), initiate an exercise-and-sell-to-cover transaction or initiate an exercise-and-sell transaction (cashless) depending on your personal situation and goals.
When your RSUs vest, you now have shares of the company you can sell at any time. You are given the shares, and taxed through your paycheck if you sell to cover or have to pay taxes on this additional income at tax time.
Stock Options and RSUs Selling Times
While they both have vesting schedules, stock options and RSUs differ in flexibility to sell. When stock options vest, nothing happens until you decide to exercise your options. You can decide to sell your options that day, or years later. However, your vested options are still tied to your employment with the company. If you decide to leave the company you will likely need to exercise your vested options within 90 days.
With RSUs, when they vest, you have shares of the company you can sell at any time. If you sell within a year it will be taxed as short term gains/ losses. If you sell after a year, the RSUs will be taxed as long term gains / losses.
How Stock Options and RSUs are Taxed Differently
Both stock options and RSUs will not be taxed when you first receive them. But, they will be taxed upon vesting. And, how they are taxed upon vesting is different.
How Stock Options Are Taxed
With stock options, how you are taxed depends on what type of stock options you have. There are two main types of employee stock options – non-qualified stock options (NSOs) and incentive stock options (ISOs). If you have NSOs, you are taxed as ordinary income when you initially exercise the stock for the difference between the current stock price and the price you bought it at. With ISOs, you get taxed when you sell the shares. If you sell the shares after holding less than a year you’ll be subject to short term gains taxes and if you sell the shares after holding longer than a year you’ll be subject to long term capital gains taxes.
How RSUs are Taxed
RSUs are given to you at $0 and they converted to the value of the company stock when they vest. When RSUs vest, that is a taxable event whether you choose to sell that day or not. Therefore, you will be taxed on the full amount at the total fair market value of your stock grant on the vesting date. When you sell your RSUs your taxes will be calculated based on the strike price. The strike price is the price of the shares when they become vested. If the shares were originally $100/ share when you got your RSU grant, but the shares are worth $50/share the day they vest you will be taxed on the $50/share price. Upon vesting, this is when you get to decide if you want to keep the shares or sell them. Whether you decide to keep or sell the shares, it’s recommended to sell enough to cover the ordinary income tax for the shares.
Are RSUs Better than Stock Options?
Ultimately, whether RSUs or stock options are best depend on your personal goals and how much you think the package you were offered will be ultimately worth.