RSUs and stock options are both forms of equity compensation to get employees to walk the extra mile and help achieve organizational goals.
But when it comes to RSU vs stock options, which instrument is best for firms and employees?
We studied both, and here’s what we think.
What Is an RSU?
Restricted stock units (RSUs) are a way for firms to compensate employees by offering them a fixed number of company shares based on a vesting schedule and other conditions.
They are attractive because as the business grows, ideally, so should the value of the company stock. Hence the employee benefits from the capital appreciation when they sell the share.
From the firms’ point of view, RSUs motivate workers to perform better so that the company grows and the value of their stocks rise.
This form of equity compensation is usually also subject to a vesting period. Vesting schedules decide when and how the employee gets the promised shares.
Typically this happens after they complete a certain work period with the company or if the firm achieves a significant milestone.
Hence, they can also help businesses with employee retention.
Types of RSUs
Depending on how the employee finally gets ownership of the promised stocks, there are two types of RSUs: single trigger and double trigger.
Single-trigger RSUs only specify a vesting period, whereas double-trigger RSUs may also have other conditions. We discuss this in more detail below.
Single Trigger RSUs
Many companies offer RSUs that vest based on an agreed-upon time schedule.
One simple way to do this is to give ownership of the securities to the employee in a graded vesting timetable.
For example, an employee can be offered 2,000 RSUs to be vested as follows: 25% after three years and then 25% each year for the next three years afterward.
This means at the end of the third year of employment, the worker will get 500 stocks, and then 500 more stocks will be added each year for the next three.
Another method is called a cliff vesting schedule. Here, the firm offers all shares at once after completing a certain number of years.
In this case, the notional RSUs have no value until they are vested, and if the employee chooses to leave before this time, they are lost forever.
Businesses might have other goals in mind apart from retaining the employee, such as:
- The launch of a product
- Listing of their stock
- Growing to a point where it is eligible for buyout or merger
When these events are added as additional criteria to the vesting schedule of the RSU, it is called a double trigger.
Do RSUs Get Taxed Twice?
Yes, RSUs can be taxed twice if they are held on after vesting, but this does not amount to double taxation.
Typically RSUs incur ordinary income tax (including any alternative minimum tax applicable) the moment they get vested, on the fair market value of the share at the time of vesting.
While most would dispose of the shares immediately, employees are obviously at liberty to hold on to them even afterward, especially if they expect the stocks to grow further.
If this is the case, and the stock price increases further by the time they are finally sold, the value difference between vesting and sale is taxed at the capital gains tax rate.
What Is a Stock Option?
A stock option is a right to purchase a stock at an agreed-on price (called the strike price) later in time.
Note that it is just a right to buy the share at that time and price – it’s not mandatory for the investor to buy.
Options may be of two types – call options are the right to buy the stock at an agreed to price, whereas put options let the holder of the share sell them at the stipulated number.
In the context of employee compensation, firms only offer call options.
They are usually offered to workers (mostly just top executives) as an additional incentive apart from salary.
These are known as employee stock units (ESUs). They differ from regular stock options available to buy and sell in the market.
ESUs can be offered only to employees and usually have more favorable terms.
Firms usually offer two types of ESUs: incentive stock options (ISOs) and non-qualified stock options (NQSOs).
The non-qualified ones are what gets offered in most cases. These get no special tax treatment and can be offered to employees, consultants, and even contractors.
ISOs, on the other hand, receive certain tax benefits, but there are limitations to issuing them.
For example, they can only be given to employees, and no more than $100,000 worth of them can be vested in a year.
Is an RSU a Stock Option?
No, RSUs and stock options are different. On vesting, RSUs are actual shares, whereas stock options merely give the employee the right to purchase company stock at an agreed price.
To put it bluntly, RSUs will definitely come into your brokerage account if you meet the conditions.
However, ESUs will only come when you opt to sell them, and the shares are above the strike price.
Why Do Companies Give Stock Options to Employees?
Just like RSUs, stock options are a way to motivate employees to work harder for the company.
Doing their role well should help the company improve and ultimately might grow the security price.
If this happens, they can exercise the option to buy the share at the pre-agreed price and make a profit by selling at its fair market value.
RSU vs Stock Options
While firms use RSUs and stock options to incentivize employees, some key differences exist, such as the tax treatment, vesting schedules, and the best time to sell. Let’s look at these more in-depth.
Both RSUs and stock options usually have a vesting schedule. This is a predefined period after which the employee can access them.
However, stock options usually only have a regular vesting timetable. RSUs often have multiple conditions linked to them.
RSUs are actual stock; therefore, giving them to an employee offers ownership in the firm (although it may only be a small part).
Hence, businesses like to add organizational performance-related conditions to vest them, such as reaching a certain revenue goal, launching a major product, etc.
When to Sell
Most employees prefer to sell RSUs as soon as they get them because the income tax applicable will be applied anyway in that financial year.
Sometimes, an employee might receive both RSUs and stock options and may not want to sell all of them.
In such a case, it might be better to sell the options but hold on to the stock. This is especially true if the share is likely to fall.
Keep in mind that options are valuable only as long as the share is above the strike price; therefore, they carry a higher risk.
Hence, for a risk-averse person, options should always be the first to sell if there is an opportunity to do it.
Firstly, stock options are worthless if the market value of the share is less than the strike price. Even if the options vest, they cannot be sold in such cases.
If they become available and the market price increases, it makes sense to exercise the option immediately and sell the securities received for a profit.
If the employee believes that the share might do even better, they may like to hold on to the option. There is no tax consequence to doing this.
However, note that stock options have an expiry date, so they must be exercised before. Otherwise, they are again of no use.
When Do You Pay Taxes?
RSUs are taxed as soon as they are vested at the eligible income tax rate of the recipient. Their worth is taken as the market value of the shares on that day.
Just like all other compensation, the income from restricted stock units is eligible for employment tax, federal tax, and other state and local taxes.
Stock options are not considered income upon vesting. They are just an “option,” not actual shares. The employee may decide never to use the option.
Hence they cannot be treated on par with RSUs.
But if and when they are exercised, the relevant capital gains tax is applicable on the difference between the exercise price and strike price.
When Should I Move From Options to RSU?
Firms should look to move to RSUs from stock options as they become older, more stable, and their valuations become higher.
Restricted stock units build in limitations that are more clearly aligned with company objectives.
For example, the firm can make its vesting incumbent on achieving certain milestones.
Moreover, from an employee’s point of view, RSUs are actual stocks – so they will hold some value when they vest.
Stock options might be completely worthless if the share price goes below the strike price. Hence, employees often do not prefer options.
This is even more true if the economy is struggling, as it is right now.
Lastly, options have a cost associated with them when they are exercised, which is borne by the employee. As firms grow, their employees will not like to bear this additional cost.
Can You Lose Money with Either?
A restricted stock unit will always hold some value.
Whatever the market price at the time it is vested, the RSU will be at least worth that much.
Even though this might be lower than the price when the employee came on board, there is still value to owning them, which can be realized by selling them off.
Stock options run the risk of becoming completely worthless.
If the stock remains above the strike price, the options are worth something, but if it goes below, there is a loss.
Unfortunately, this is a huge drawback from an employee’s point of view.
They expect to get at least something for their effort, even though it may be notionally lower than what they thought it would be when they agreed to take the option in the first place.
What Happens if You Leave the Company?
When exiting the firm, vested RSUs remain with the employee, whereas non-vested ones usually get forfeited.
Since vested shares are already in your brokerage account, they can be kept or sold, depending on what you wish to do with them.
For stock options, the principle is slightly different – in most cases, the employee is not allowed to continue to hold the option.
They can exercise their right to get shares against those already vested options. However, those that are not yet vested are lost.
Is It Better to Take RSU or Stock Options?
For someone looking to minimize the risk on their compensation, RSUs are the right option.
As noted earlier, RSUs always have some value, even if the company shares go down. However, options can lose their worth entirely if the stock price breaches the strike price.
From a taxation standpoint, however, stock options are more flexible since they are not taxed until the option is exercised. RSUs get taxed the moment they are vested.
Are RSUs Worth It?
Yes, RSUs offer the employee an incentive to work towards the organizational goal and reward them when it gets achieved.
They become direct shares (not share derivatives) in the company when they are vested, so there is always some value to be gained by the employee in getting them.
Are Stock Options Worth It?
Stock options also incentivize employees to work harder. However, they are a riskier alternative to RSUs.
If the company’s share prices do not go up, the employee loses their compensation due to no fault of their own.
On the flip side, there is a higher reward for the risk involved in stock options – their payout is usually much higher than stocks.
Lastly, options give more flexibility to the employee to manage their taxes because they don’t get taxed immediately on vesting.
Both RSUs and stock options are the “extra something” which firms can offer to employees to motivate them to achieve organizational goals.
While both methods can be rewarding, RSUs are less riskier than options because they are direct shares, not financial derivatives.
Unlike stock options, they will always have some value and can never become a complete loss.
They are also easier to understand for employees, and their taxation is simpler.
Stock options might offer higher rewards when they work out, ie, when the share price goes above the agreed price.
Moreover, options are not taxed until they are exercised, so the employee has more flexibility to manage their tax liability with this instrument.
Typically, smaller organizations such as early-stage startups start out by offering employee stock options but, over time, move to RSUs as options can quickly dilute equity.