Stock Options vs. RSUs: What’s the Difference?

Stock options and restricted stock units (RSUs) are two kinds of equity compensation organizations offer you. Employees receive equity compensation in the form of restricted shares and stock options. A stock option is paid in stock, whereas an RSU is paid in cash or stock. 

Intro

Understanding how to reap the rewards of stock benefits while mitigating the risks is essential when accepting a job offer. It would help if you first understood stock options vs RSU. You can purchase stock options for a limited number of years at a predetermined price, known as a strike price, in your company's stock. By the time your options vest, the strike price of your stock will be lower than its fair market value if your company is performing well. This means your company stock can be bought for a low price and sold at a higher fair market value. The most common type of equity compensation is restricted stock units (RSUs), typically offered after a company goes public.

As with stock options, RSUs vest over time, but you are not required to purchase them, unlike stock options. The shares vest immediately, just like if you had purchased your company's stock on the open market. They can be sold, and you will receive a profit. You should negotiate your equity compensation in the same way as your cash salary. When you sign a job offer, most companies will grant options or RSUs. Consider your financial situation and your comfort level with risk when deciding how much stock to hold. Ensure you balance both the risks and the rewards of concentrating your investments around a single company. Keep this from becoming a significant part of your net worth.

What Are Stock Options?

With a stock option, you can purchase equity in a company within a specified timeframe at a predetermined price. The opportunity to buy the shares is available to you, but you have no obligation to do so. Stock options contracts typically represent 100 shares of the company you are purchasing.

As described above, employee stock options are commonly referred to as stock options. When you get a job at a company, you can buy stock in the company as part of your compensation. Vesting often entails working at the company for a certain amount of time, such as a year, before you can purchase stock. It prevents short-term employees from accumulating valuable stock in a company.

One of the most significant advantages of stock options is that you can purchase them at a set price that may end up being much less than the stock's market value when the option vests. There can be a specific schedule for the option to grant. If you have 1,000 shares, you can exercise 250 shares per year. Additionally, some stock options may have an expiration date after which they can no longer be exercised.

When your options vest, your strike price should be lower than your stock's fair market value if your company performs well. As a result, you can buy your company's stock for a lower price and sell it for a higher price. If your company's stock price rises over time, this can lead to a significant financial gain. If your company's stock price doesn't rise above the strike price of your options but still performs poorly, your options will be worthless.

However, you're not risking any of your capital until you exercise your stock. In this way, stock options let you have some skin in the game without investing any money upfront. The tax treatment of employer-granted stock options varies depending on whether they are incentive stock options (ISOs) or non-qualified stock options (NSOs). The vesting of stock options usually takes place after you have worked for the company for a certain period. 

What Are RSUs?

A restricted stock unit (RSU) is the most common form of equity compensation and is typically awarded after a private company goes public or achieves a more stable valuation. The vesting period for RSUs is similar to that for stock options, but unlike stock options, you do not have to purchase them. After vesting, these shares are no longer restricted and are treated the same as if you had bought them on the open market.

RSUs have a lower risk than stock options because of this. Your stock will always be worth something if it doesn't drop to zero. The vesting of RSUs usually takes place over several years. Typically, after your first year of employment, you receive 1/4 of your RSUs, and every month afterward, you receive 1/36 of the rest of them. Your ordinary income is taxed based on the value of the shares at the date of vesting. The vesting of RSUs encourages employees to stay with the company longer, just like stock options.

Employees receive RSUs in the form of shares of company stock as compensation. RSUs do not have to be exercised - once they vest, they belong to you. Employees of public companies were more likely to receive RSUs than those of private companies in the past. RSUs, however, have become more prevalent in private companies in the last 20 years, especially those that have closed rounds of funding with large valuations (over $1 billion), even when their valuation won't be realized or justified for a few years. Vesting is usually required for RSUs, just as it is for stock options.

Stock Options vs. Restricted Stock Units: What’s the Difference?

Your compensation may include some form of equity that depends upon the company you work for, such as stock options or RSUs (restricted stock units). For trading, you must clearly understand different types of equity compensation with their advantages and how the taxation performs for the same. Before proceeding, you must know how to adjust your financial plans accordingly.

There are several pros and cons to both stock options and RSUs. The choice you are going to make relatively depends largely on preferences classified on behalf of your aspect and a few external factors. let's discuss the breakdown of some of the significant differences te between RSUs and stock options in the upcoming section.

Pros and Cons of Stock Options 

Stock options are usually better for both parties when any company is in its early stages. RSUs tend to be better for both a later-stage company and its investors. Unlike Restricted Stock Units, which promise to deliver a share of stock at vesting, Stock Options allow the option to purchase stock after vesting, but at a fixed price. Because stock options can be invested, they are potentially more favorable tax-wise than RSUs, which are considered deferred compensation.

Pros of stock options:

• While the company is still private, stock options can be turned into shares that can be sold. Although permission is usually required, this can often be done, unlike an RSU, which cannot be transferred at all.

• As long as the employee gets more shares and the strike price is low, there is not much difference in value between the RSU and the employee's stock options.

• Exercised stock options can reduce taxes if the long-term capital gain is qualified or no taxes if the stock is qualified.

• Exercise prices and associated taxes protect the company from losing employees. Even when it is enacted early so that tax advantages can be gained, When employees have a stake in the company's success, their interests are better aligned.

• In addition to continuing to appreciate and deferring taxes even after the IPO, stock options can be retained even after the IPO. RSUs, on the other hand, trigger taxes upon an IPO.

• Employees who exercise earn cash for the company. Employees who pay taxes on options receive a tax deduction from the company.

• Employee taxes are adversely affected by rapidly rising FMVs. The fact that companies are motivated to slow down the 409a FMV growth while issuing options is, a positive development for the industry. Companies are motivated to increase FMV during the RSU-phase.

Cons of stock options:

• In addition, as the FMV rises, the high exercise price does not attract new employees. They are worried about losing their shares and paying the high exercise price.

• When you leave a company, your options typically expire 90 days later. On the other hand, NSOs can have a more extended expiration period, and companies can easily convert ISOs to NSOs.

• Taxes can be triggered by exercise. AMT can be avoided if a block of ISOs is small, but the $100K limit rule limits this benefit. When an NSO is exercised, withholding tax is always due.

• When the FMV of a stock option is lower than the exercise price, it becomes underwater and worthless. Initially, options are granted at the fair market value (FMV), so recipients are often unaware of the deal. Therefore, they focus on percentage ownership instead, which is not sustainable for businesses.

• The company recognizes the income tax on a stock option until the optioned does. A company's stock price volatility can mess up earnings reports for companies concerned with their reported earnings per share.

Pros and cons of RSUs 

Pros of RSU:

• The employee can't purchase an exercise price. Instead, they get the entire value of the stock equivalent. As a result, an RSU is never underwater.

• Options can harm a company's earnings more predictably than they would if it cared about reporting earnings.

• Many companies understand how to grant fair treatment to employees who arrive at different times. 

Cons of RSU:

• Upon vesting of an RSU, an restricted stock unitsis always subject to the high ordinary income tax rate. Filing IRS 83(i) elections for a 5-year deferral is rare. The RSU value will be the subject to income tax, but any additional gains will qualify for capital gains treatment.

• The shares do not vest until liquidity is achieved, and the date of the IPO or M&A event is outside your control. Companies are not required to reissue RSUs that expire within 5 to 7 years.

• RSUs can't be transferred or sold while the company is still private.

• RSUs are not eligible for 83(b) filings at grant to lock in lower taxes.

• Even if you do not intend to sell shares, IPOs trigger taxes on RSUs. If you sacrifice a portion of your shares, you can either defer taxes or defer a portion of your taxes by filing an 83(i).

• Whether you sell RSUs or not, post-IPO vesting increases your tax bracket. You will be have to pay tax at a higher rate, even on your regular W2 earnings. You must turn in more shares than usual if you are turning in shares to cover taxes.

• In the case of companies where employees turn in shares for tax purposes, the company will still have to send money to the IRS instead of claims. It is an inferior use of the proceeds of IPO share sales, which usually have to be disclosed in the prospectus.

• Companies do not benefit from retaining employees when they have to exercise options. It may make employees who don't care about taxes happy if a company grants large blocks of RSUs early because they seem cheap, but it may ruin the company as a whole. 

Stock Options vs. RSUs: Which Is Better?

You will make more money if and when your company's value rises due to your success in your role when you sell your stake. This is generally true. The first thing to understand is how equity compensation works, what the advantages are, and how they are taxed.

Stock options and RSUs each have their advantages and disadvantages. In addition to your own preferences, a few other factors will influence your decision. Here are a few of the main differences between RSUs and stock options: Taxes are a significant factor. Taxes on RSUs are based on income, so capital gains taxes do not apply.

Non-qualified stock options (NSOs) and incentive stock options (ISOs) are the two types of stock options. The market price minus the grant price is taxed for NSOs. Taxed as regular income, this is called the spread. Taxes includes Social Security and Medicare are imposed on it, and income taxes and payroll taxes.

Payroll taxes aren't applied to ISO spreads. Instead, it is included as a preference item in the calculation of alternative minimum tax (AMT). Alternative minimum taxes, which are separate from regular tax laws, can be complicated, so you may benefit from getting the help of a financial advisor.

Additionally, you should consider how you think the company will perform in the future. The stock's market value must be greater than the grant price at some point during the vesting period for stock options to be valuable. Unless you do this, the shares would cost more than they could be sold for in theory. The RSUs, on the other hand, are a pure gain since you do not need to pay for them.

For the mentioned reason, companies need to offer a few RSUs rather than a traditional stock options. If you have to choose, you should think about whether the prices are getting high enough to make taking the risk on stock options worthwhile or if you prefer the relative safety of RSUs.

Final Thoughts

Companies give their employees stock options to purchase the company's stock at a predetermined price at a given time. Shares may be vested over a series of years, with several claims becoming available each year. As opposed to RSUs, which are grants of a stock that employees receive without purchasing them. Employees receive these either in the form of shares or cash equivalents.

It is challenging to decide stock options vs. RSUs, as both have pros and cons. There is generally no risk associated with RSUs since no money is spent to obtain the stock.