Stock incentives are one of the most effective methods for a firm to involve its employees in creating long-term company value. Providing employees with stock motivates them to contribute to the company's success and profit growth. Employee stock options (ESOs) and restricted stock units (RSUs), two of the most prevalent employee stock programs, allow you the opportunity to someday become a stakeholder in your firm. There are considerable distinctions between these advantages, despite their apparent similarity.
What Are Stock Options?
A stock option allows you to acquire a firm's shares at a certain price and within a specified time frame. You are not required to acquire the shares, but you have the option to do so if you believe it would be prudent. Typically, one stock option contract corresponds to 100 shares of the company you are investing in.
The word stock options refer to the employee stock option explained above. As part of your remuneration for accepting a position at a company, you are offered the chance to purchase stock in the company. This is commonly accompanied by a vesting schedule, which stipulates that you must work at the firm for a particular amount of time, often one year, before you are eligible to acquire stock. This is done to prevent short-term employees from acquiring potentially valuable firm stock.
One of the greatest benefits of stock options is the ability to purchase shares at a price that may be significantly lower than the stock's market value when the option vests. The stock options may vest on a predetermined timetable. For example, you may be allowed to exercise 250 shares a year for 1,000 shares. There may also be an expiration date after which you lose the ability to execute stock options.
Typically, stock options are suitable for early-stage, high-growth start-ups whose prices are projected to climb dramatically, especially if the business grows and receives further funding rounds. Typically, these businesses have no income and may not even have a product. It is possible that they will never be lucrative, but if they are successful, the benefits can be substantially bigger.
With stock options, employees are granted the right to buy the company's stock at a fixed price and within a specified timeframe, similar to a call option. They will be liable to Capital Gains Tax upon sale, but if the option plan is put up properly, no tax will be due until the sale.
Pros And Cons of Stock Options
Pros
The employee can acquire additional shares, and the strike price is low enough that the difference in value between one RSU and several RSUs is minimal.
A stock option can be converted into tradable shares while the firm is still privately held. This needs authorization but is possible, whereas an RSU cannot be moved at all.
A stock option can be exercised at nearly any time in order to qualify for lower taxes on Long-Term Capital Gains or no taxes on Qualified Small Business Stock.
Even after the IPO, a stock option might continue to appreciate in value while taxes are deferred. On the other hand, RSUs are taxed upon an IPO.
The exercise price and related taxes serve as a retention tool to prevent employees from leaving the firm. Even when exercised early to reap tax benefits, having skin in the game has the impact of better aligning employee and employer interests.
Rising FMVs are detrimental to employee taxation. Consequently, it is fortunate that firms are driven to restrict the increase of the 409a FMV while granting options. During the RSU period, corporations have an incentive for the FMV to increase.
If an employee exercises, the employer receives monetary compensation, and the corporation receives a tax break if the employee pays taxes on options.
Cons
As the FMV increases, the high exercise price becomes less desirable for recruiting new personnel, especially if they are apprehensive that they may be required to depart and pay the high exercise price to keep the shares.
Exercising might result in a hefty tax bill. Small blocks of ISOs can escape AMT. However, the $100,000 Limit Rule limits this benefit. On exercise, NSOs are always liable to immediate withholding tax.
Options often expire 90 days after an employee leaves a business. NSOs can have a longer expiration date, and ISOs can be readily converted to NSOs if the corporation so chooses.
The corporation pays the income tax on a stock option until the optionee recognizes it. Companies who care about their stated earnings per share will dislike it when their stock price volatility messes with their earnings report.
A stock option may be underwater and void if the FMV is below the exercise price. Since options are issued initially at the FMV, recipients are frequently uncertain of the value. As a result, they emphasize percentage ownership, which is an unsustainable business strategy.
How Do Stock Options Function?
An employee stock option plan grants employees the right (but not the responsibility) to purchase company stock at a certain price and on a predetermined date. Employees do not get whole shares of stock under a stock option scheme, and they are instead given the option to purchase stock in the future, which may or may not be useful.
Employee stock options function similarly to options traded on public markets.
All stock options, including employee stock options, refer to the share price on the option's expiration date as the "strike price." The options should be exercised if the market price per share is greater than the strike price. If the stock's price falls below the strike price, the options expire worthlessly.
Some employee stock options provide a length of time to exercise once the vesting date has been reached. Consequently, if your options are initially out-of-the-money, you can wait for the stock price to rise.
What Are RSUs?
Restricted Stock Units (RSUs) are a kind of stock-based remuneration with restrictions. It is a pledge by the corporation to provide the employee with company stock if certain conditions are satisfied. These obligations may include meeting particular performance standards or remaining with the firm for a specified period of time. RSUs do not necessitate too many considerations about their disposition.
Pros And Cons of RSUs
Pros
Both the employer and employee will be interested in the organization's success.
It encourages the employee to perform harder since they will receive additional income.
Cons
RSUs are taxed in accordance with your federal and state tax brackets.
If the employee is terminated, they will forfeit all unvested shares.
How Do RSUs Work?
Employers often issue RSUs to employees under an RSU plan depending on specific circumstances. These include working for the firm for an extended period of time and achieving performance goals.
If the employee accepts the award and meets the vesting criteria, he or she receives either the shares of stock or a cash equivalent. Some schemes delay the delivery of shares to a later period, either automatically or voluntarily. Once you have ownership of the shares, they are yours and unrestricted.
If you leave a business with unvested RSUs, you may lose them. With a fully vested RSU, you should be able to keep the shares of the firm even if you leave the company.
Workers who trust in the long-term viability of their firm may choose to hold on to their shares for many years after leaving the company. Too much of your wealth should not be invested in a single company's stock. However, there is no reason why it cannot be included in your long-term portfolio.
Is RSUs Valuable?
While stock options are the most common type of equity compensation, RSUs are often reserved for firm executives and senior employees since they are more difficult to get.
When you are awarded stock options, you are granted the right to acquire company shares at the strike price in the future. Although you may be able to get the stock at a discount, you must still pay for it. RSUs, on the other hand, are stock-based remuneration. Unlike stock options, you will not be required to purchase your shares.
As an employee, you may not have the option to choose between stock options and RSUs; the corporation will determine which to provide. RSUs are effectively free stock, so if your firm gives them, they are certainly worthwhile.
Now that we've defined RSUs and stock options let's examine the fundamental distinctions between these two forms of equity.
1. RSUs do not have an exercise price, but stock options do.
This may seem simple, but the absence of an exercise price is a significant distinction between RSUs and stock options. Let's disassemble it:
To convert RSUs to common stock, an employee needs merely to comply with the vesting timeline or plan.
With stock options, the employee has the option, or choice, to purchase or sell the stock at a certain exercise price.
2. RSUs have value even if the value of the firm does not increase, but stock options do not.
Some entrepreneurs choose stock options because they motivate employees to increase the company's worth more effectively. Consider: if you are awarded stock options at a specific valuation, you will likely work diligently to ensure that the company's valuation increases since this will increase the value of your stock options. The stock options become less attractive if a company's valuation remains stable or declines.
In contrast, RSUs keep a portion of their value regardless of how well the firm does in the following months and years. This worth may not amount to much if the company's value declines, but it still represents some value. This is essential when selecting the number of RSUs or stock options to include in an equity package. In general, an employee would earn fewer RSUs than stock options in a nearly equivalent equity package.
3. Different taxes apply to RSUs and stock options.
Taxes aren't only your workers' problem. From the perspective of the IRS, RSUs and stock options are not the same, and this distinction can significantly impact the value of an equity package. In reality, these two forms of equality have quite distinct tax consequences.
With RSUs, employees are exempt from taxation at the time of the award. However, they must pay taxes when the RSU is fully vested and cashable. RSUs are taxed at state-specific ordinary income tax rates.
With stock options, the situation is somewhat more difficult. In general, options are taxed only when they are exercised; however, the particular taxes you'll pay may vary depending on the type of option. Depending on whether the option is an ISO or an NSO and how long the stock is held after the option is exercised, profits or losses may be categorized as either short-term or long-term capital gains or losses. Moreover, ISOs may be subject to the alternative minimum tax (AMT), which is meant to ensure that some taxpayers, often those with high incomes, pay at least a minimum tax, therefore restricting their potential tax deductions and exclusions.
There are advantages and disadvantages associated with both stock options and RSUs. The choice between the two will rely on your own circumstances and other issues, such as taxation. RSUs are taxed at regular income tax rates upon vesting and liquidation. Employers often withhold a percentage of the RSU to pay taxes, similar to how they withhold a portion of salary and earnings to pay income taxes. However, you may be offered the option to pay taxes with cash on hand in order to keep all of your vested RSUs.
In contrast, stock options are not subject to taxation until they are exercised. If you hang on to stock options for at least a year, they will be taxed at more advantageous capital gains rates. Until a firm goes public and the employee can sell enough shares to satisfy the tax owing on the appreciation, stock options are often not exercised.
Important to remember is the fact that stock options are only valuable if the price of the underlying stock increases in the future. If the stock price does not rise, you will spend more for the shares than you might receive by selling them. In contrast, the value of RSUs is not dependent on the future stock price increase. They are provided by the company after specified performance criteria are satisfied or after a certain period of time has indeed been invested with the organization.
This is one of the reasons why RSUs are less prevalent than stock options. If given the option, you should assess the potential advantage of significant price appreciation, which might make stock options incredibly valuable in the future, against the risk that the stock price will not increase and the options will be worthless. In contrast, RSUs are reasonably secure because their value is not contingent on the increase in stock price.
The Bottom Line
RSUs and stock options are types of equity compensation companies may provide their employees to recruit and retain talent and recognize their achievements. Which you have access to mostly depends on the organization you work for and the position you have.
Some businesses give RSUs, while others prefer stock options. Additionally, some firms give various kinds of payments to a limited number of employees. RSUs and stock options are supplementary types of remuneration, in addition to your salary, 401(k) match, and health insurance plan, and should be considered when accepting a job offer. There are advantages and disadvantages to both stock options and RSUs, making the selection between them difficult. It boils down to RSUs being less risky since they do not need payment to acquire the stock. Bear in mind, though, that as an employee receiving either, you will likely not have a choice. Before deciding on your whole compensation package, it is essential to understand what is being given and how it functions.
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