Understanding the difference between RSUs and stock options: Employee incentives explained
Discover the distinctions between RSUs and stock options, crucial employee incentives that vary in how they vest and their tax implications.
Since the 1990s, the notion of "sweat equity" has evolved, recognizing employees' value through effort, skills, leadership, or intellectual property. Today, companies often offer RSUs and stock options as forms of compensation, each tied to the company's stock price. However, they differ significantly in structure and benefits, prompting consideration of which option may be more advantageous.
Origins of stock options and RSUs for startups
Startups have various ways to incentivize employees beyond perks like inflated job titles and foosball tables. Recognizing the importance of compensating employees with potential future growth, companies often use stock options and RSUs. These equity-based incentives align employee interests with company success, crucial for attracting talent in early-stage ventures where cash flow may be limited initially.
Understanding RSUs: Definition and mechanism
Despite its technical name, RSUs are straightforward compared to stock options. Both RSUs and options reward employees later for current work. RSUs involve a company promising free shares or their cash equivalent. For example, if Jonathan Jellybean joins a newly IPO'd company, he might negotiate a lower salary in exchange for 1,000 RSU shares next year. This benefits the company by conserving cash, while Jonathan gains potential if the stock price rises. After the RSU vesting period, Jonathan receives the shares without cost, which he can sell for profit, even if the company fails.
Understanding stock options: Definition and operational mechanics
Unlike stock options traded by investors, employee stock options are granted as a form of compensation. The holder gains the right to purchase company shares at a predetermined price in the future. If the share price exceeds the agreed-upon "strike price," the holder can profit. However, if the shares' value drops below the strike price, the holder can choose not to exercise the option without financial loss. Unlike purchased options, these employee incentives are provided at no cost to the recipient. For example, Kelly Knickerdoodle receives stock options in her employment contract, allowing her to buy shares at $15 each after two years. When the vesting period ends with shares valued at $20, she buys them for $1,500 and sells them for a $500 profit the following day.
Comparing RSUs and stock options: Evaluating their merits
Text: In the comparison between RSUs and stock options, RSUs are often contingent on specific conditions like a company going public or meeting performance milestones, which can make them less appealing to employees. Conversely, stock options may become worthless if the stock price falls below the strike price, requiring the holder to have funds to exercise them. Jonathan receives RSUs without cost, ensuring some value even if less than anticipated, while Kelly's options require upfront investment and risk of total loss if the stock price drops below the strike price.
Main contrasts between RSUs and stock options
| Basis of comparison between RSUs and stock options | Stock options explained | RSUs explained |
| Definition | Right to acquire shares at a pre-agreed price in the future. | Company shares awarded upon achieving performance milestones or fulfilling tenure criteria. |
| Issuer | Small, early-stage companies focused on rapid expansion | Corporations with substantial valuations, publicly traded companies |
| Exercise price | Companies with significant market capitalization and those listed on stock exchanges. | No |
| Shareholders’ rights | Complete shareholder rights upon option exercise | Limited rights until vesting and settlement |
| Voting rights | Granted | Not granted |
| Сost on vesting | No upfront cost upon vesting | Require payments upon exercise |
| Value dependency | Value fluctuates with stock price and can potentially drop to zero. | Value solely tied to stock price, becoming zero only in case of company bankruptcy. |
Tax implications of options vs. RSUs
Text: When considering the vesting of stock options or RSUs, it's crucial to understand their tax treatment, which can vary between capital gains and ordinary income. RSU taxes are typically based on total income in the year of exercise, potentially qualifying for capital gains if held long-term. Stock options are generally subject to immediate income tax, possibly affected by the Alternative Minimum Tax. Unlike RSUs, options may offer the option to spread tax liability over time. Seeking advice from a financial planner and utilizing tax-deferred accounts like 401(k)s or IRAs can help mitigate tax obligations.
