Employee stock options and restricted stock units (RSUs) are both forms of stock-based compensation that companies can use to incentivize and reward employees. There are some differences between these two methods of stock-based compensation, however.
What Are Stock Options?
A stock option gives the option holder the right, but not the obligation, to buy or sell a specified number of shares of a stock within a specified period. Stock options are widely used among investors; employee stock options are just one type of option.
Stock options are a form of stock-based compensation that can be used to reward certain employees or groups of employees. Stock options can provide an incentive for employees to perform well in their jobs in order to help the company grow. They can also provide an incentive for employees to remain at the company at least long enough to become vested in the options.
There are a few key terms surrounding employee stock options to know:
- The grant date is the date on which the company granted the options to you.
- The vesting date is the date at which you gain full control and ownership in the options. Options typically vest according to a vesting schedule that starts with the grant date. For example, the vesting schedule for options granted to you may vest over a five-year period, with 20% of the options vesting each year. In other cases, vesting may occur all at once. Once you are vested in in some or all of the shares covered by the options you are able to exercise the options to buy the corresponding number of shares at the option’s strike price.
- The strike price of the options is the price at which you can purchase the shares by exercising the options. The strike price will generally be set at a higher level than the market price of the stock on the date the options are granted. The market price once you become vested in the shares covered by the options may be higher or lower than the strike price.
- The expiration date is the date at which your options expire worthless if you fail to exercise them. If the stock’s market price remains below the strike price it of course wouldn’t make economic sense to exercise the options.
What Are Restricted Stock Units (RSUs)?
RSUs are another form of stock-based compensation that companies can offer to employees. An RSU is a grant based on the underlying value of the company’s stock. There is typically a vesting period for the grants, after which time the RSUs are distributed to the employees as shares of the company’s stock. In some cases, the value of the RSUs may be distributed as cash to the employees.
Until vesting occurs, RSUs are simply an unfunded promise to issue the shares to the RSU holder. Recipients of RSUs should understand:
- The details of the vesting period— is it based on the passage of time, the achievement of individual or company goals, something else?
- What happens to the RSUs in the event the employee is terminated or otherwise leaves the company prior to their vesting? What happens if they should die?
- What is the fate of the RSUs in the event of a change in control of the ownership of the company?
Stock Options vs. RSUs: Key Differences
Both employee stock options and RSUs are valid forms of stock-based compensation. There are some key differences.
Some Level of Value
With stock options, if the market price of the stock is below the strike price during the exercise period, they could expire worthless. Why would the holder of an option pay more than the market price of the stock to buy shares?
RSUs, on the other hand, generally have some value. Since RSUs are distributed as shares of stock versus stock options where the holder has to purchase the shares, the RSUs will generally always have some value.
The tax treatment between RSUs and stock options is different as well.
With RSUs, you are taxed when you receive the shares associated with the RSU. The taxable amount is based upon the market value at the time you are awarded the actual shares. Additionally, should you later sell the shares, any gains would be taxed at the applicable capital gains rate.
With stock options, there are two types of employee stock options and each has a different tax treatment.
- Incentive stock options (ISOs) are not taxed per se, rather any gain on the sale of the shares after the options are exercised is taxed as either a long-term or short-term capital gain depending upon your holding period for the shares prior to selling.
- Non-qualified options are taxed when you exercise the options. The difference between the exercise price of the option and market price of the stock at the time the options are exercised is taxed in that year as ordinary earned income, and as such would be subject to normal payroll taxes as well.
Stock Options vs. RSUs: Which Is Better?
Like many financial questions, the answer depends.
If the company’s shares are increasing in price, then the employee might be better off with stock options in that they offer the opportunity to purchase the shares at a price that is below the market price for the shares.
Additionally, with stock options:
- You may be able to retain your rights to exercise the options should you leave the company, depending upon the terms of the option grant.
- With stock options you have some flexibility as to when you exercise the options and hence some flexibility as to timing of when taxes are paid.
RSUs are generally always worth something versus stock options, which can expire worthless if the stock price is below the strike price. Additionally, with RSUs you don’t have to come up with the cash to exercise the options if your company doesn’t offer some sort of cashless exercise option.
Stock options and RSUs can both be valuable forms of compensation for employees. Which is better will depend upon a number of facts and circumstances surrounding the company and the employee’s situation.