With all of the big IPOs happening this year – Uber, Pinterest, Lyft, and more – we’ve been taking a lot of time here on Daily Capital to review the nuts and bolts of employee equity compensation. RSUs and stock options are both common ways that employers compensate their employees with equity, but companies don’t always do the best job of educating folks on what their holdings are actually worth. The first step towards understanding the value of your equity is simply knowing the ins and outs of how it works. So, let’s break it down.
Stock Options vs. RSUs
Restricted stock units (RSUs) and stock options are both forms of employee equity compensation – or non-cash compensation — offered to an employee by an employer. RSUs and options are generally the most common forms of equity compensation, but they are very different and you will want to approach them with different strategies to maximize your net worth. So, what is exactly is the difference between RSUs vs. stock options?
We generally recommend that people work with a financial advisor to evaluate their strategy around employee equity – RSUs and options can be fantastic building blocks when it comes to your net worth and financial goals, but they also have complex rules around tax treatment, and people often run the risk of being over-concentrated in their company stock.
What Are Stock Options?
Stock options are probably the most well-known form of equity compensation.
A stock option is the right to buy a specific number of shares of company stock at a pre-set price, known as the “exercise” or “strike price,” for a fixed period of time, usually following a predetermined waiting period, called the “vesting period.” Most vesting periods span three to five years, with a certain percentage of options vesting each year (which means you’ve “earned” your shares), though you still need to exercise (i.e., purchase them).
With stock options, if you wait to hit certain milestones, your tax treatment may be better. You could receive favorable tax treatment if you wait for two years from grant date and one year from date of exercise to sell your shares. Once these two milestones are met, any profit you generate from the sale of your stock will be taxed as long-term capital gains. (Note: this holding period is only applicable to ISOs, and you could be subject to taxation when you exercise the share.)
Keep in mind that these are very high-level guidelines; since every situation is unique, you should check with a professional to see if these apply to you.
What Are RSUs?
Restricted Stock Units are a type of restricted stock (which may also be known as “letter stock” or “restricted securities”). Restricted stock is company stock that cannot be fully transferable until certain restrictions have been met.
These can be performance or timing restrictions, similar to restrictions for options. You can think of restricted stock as a bonus awarded as stock instead of cash; however, like cash, it is taxed as if it was paid in cash (i.e., as ordinary income).
Restricted stock can be a popular alternative to stock options, particularly for executives, due to their favorable accounting rules and income tax treatment. There are two basic types of restricted stock: Restricted Stock Awards (RSAs) and Restricted Stock Units (RSUs).
Restricted Stock Units can be awarded on regular vesting schedules or performance benchmarks, which means that the value of the RSUs on the day of vesting is subject to payroll and ordinary income taxation.
What is the Difference Between Stock Options vs. RSUs?
The key difference is that RSUs are issued in the form of units – not stock – that correspond in number and value to a specified number of shares of employer stock. Upon vesting, you’ll get your equivalent shares.
With stock options, the incentive is the possibility of owning stock of the company at a discounted rate compared to buying the stock on the open market.
Stock options and RSUs are both popular forms of equity compensation and can ultimately result in a significant piece of your net worth. Therefore, it’s important to fully understand tax implications and how your equity might weight your overall portfolio. Working with a financial advisor is a good way to help tease through these complexities.