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Stock Options Vs. Restricted Stock Units (RSUs)

Stock Options Vs. Restricted Stock Units (RSUs)

Restricted stock units (RSUs) have broken the mold as a form of compensation to employees of startups in recent years, so we’re breaking down the definitions and fundamental differences between stock options and restricted stock units to help you decide what’s right for your company. Startups have historically used stock options almost exclusively to allow their valued employees to share in the company’s success. Over the last decade or two, the trend started to shift as RSUs emerged as a popular form of compensation.

Each choice has its pros and cons, and various factors related to your business, tax treatment and voting rights should help you decide on the best way for your company to go.

What Is the Difference Between Stock Options and Restricted Stock Units?

As an employer, you have various ways of compensating your employees — paying wages, offering health insurance and paid time off, and potentially offering compensation in the form of the company’s equity. Your company will need to weigh the difference between stock options versus RSUs in putting together your employee benefits packages.

Before we dive too deeply into the specifics of RSUs vs. stock options, let’s visit a brief history of how stock options got started. Stock options date back to the early 1970s. An attorney in Silicon Valley designed them as part of a capital structure for startups to support the boom in the high-tech industry. The goal was to create a model that venture capitalists would find attractive and provide employees with a valuable incentive to help the company succeed.

In the early 2000s, the IRS created a new rule to set option strike prices at the fair market value of the common stock at the time the option was issued. This was to prevent companies from getting too much in untaxed benefit. Since the new rule, companies that issue stock options at prices below the fair value of the common stock create a situation where options are taxed on the amount that the market value exceeds the cost to exercise.

Now, let’s look at the difference in definitions between stock options vs. RSU:

Stock Options — Gives the holder the right to buy a company’s stock at a future date at a price established at the time of issue.

Restricted Stock Units — Gives the holders a commitment to receive the value of a certain number of shares in the future without requiring payment upfront. These units are generally subject to vesting periods.

The Key Differences

There are advantages and disadvantages of stock options and RSUs. To better understand RSUs versus stock options, let’s look at some of the terms that define them.

  1. Grant date: This term refers to the date an employee receives stock options or RSUs.
  2. Exercise price: This term is also called the strike price. Your company uses the exercise price to calculate the dollar amount needed to exercise the options and also uses it as a basis for factoring taxes. To exercise the options, the holder pays the strike prices times the number of options they have vested in exchange for their shares.
  3. Vesting: This is the process of earning stock options. Your company may offer RSUs or employer-matched contributions in exchange for working for the company over a certain period. It’s an incentive to encourage employee retention.
  4. Payment: This term refers to the type of payment holders receive, which can be in the form of stocks or cash.
  5. Taxation: This term refers to how restricted stock units vs. options are taxed and whether they’re taxed as regular income or preferred items with a lower tax rate.

RSUs vs. Stock Options: What’s Right for Your Company?

How can you make the right decision for your startup? The following table breaks down stock options vs. RSU by the factors that may influence your decision. The table also clarifies how your company’s maturity plays a factor in making the best choice.

With stock options, you enable your employees to buy stock at a predetermined price at a specific time. Stocks may become available because of a vesting schedule where a certain number of shares are available every year over a period of years.

Stock Options vs. RSUs

CharacteristicsStock OptionsRestricted Stock Options
Exercise priceBased on full market value of underlying securityNone
VestingCan be vested anytime for any designated milestoneCan be vested anytime for any designated milestone
PaymentStockStock or Cash
Voting right / DividendsUpon exerciseNo, but company may give a dividend equivalent as a bonus
TaxNSOs treated as regular income; ISOs as preferred items for alternative minimum taxTreated as regular income (stock held more than a year treated as capital gains) and taxed upon vesting
Popular for this type of companyEarly stage, high growth startupsCompanies that are more mature, later stage
RationaleGreater potential for increase in value, employees can time taxationTaxes are due at the time of vesting, sale of mature stock may support required payment

By contrast, RSUs are grants that your company gives your employees without employees having to buy them. Employees have the option of taking them as shares or as a cash equivalent.

Another big reason companies opt for RSUs is because they’re less risky as employees don’t have to spend any money to get the stock. RSUs allow companies to provide an equity incentive to employees where the current company value won’t be achieved until it has matured more. You could think of RSUs as sort of an unfunded promise to issue shares of stock or cash equivalent in the future.

With the pros and cons of restricted stock units vs. options sorted out, let’s take a closer look at the tax treatment of both choices.

How Does the Tax Treatment of Stock Options and RSUs Differ? (Needs further check with legal..)

We’ve touched on some of the ways that stock options versus RSUs are subject to taxes and which taxes apply. RSUs and stock options were created for very different purposes. For that reason, they’re taxed differently. It’s essential to understand the tax implications so you can make the right choice for your company. Knowing the differences in how stock options and RSUs are taxed will also help you inform your employees of the tax implications related to their decisions.

Let’s take RSUs first. As soon as RSUs become vested and liquid, they’re taxable. It’s common for companies to withhold some RSUs to pay for taxes that will be owed when they’re vested. You may also give your employees the option of paying taxes with cash so they retain all vested RSUs. This is a crucial consideration because, depending on the circumstances, the taxes can be high. Between federal and state taxes, the tax rate could be as high as 48%, depending on the state you live in and the value of your RSUs.

By contrast, stock options don’t get taxed until they’re exercised. Employees that exercise their options before the value of the options have increased and file an 83(b) election won’t have to pay taxes until the options are sold. Employees that choose to hold onto their options for at least a year post-exercise will be taxed at the capital gains rate. The taxable gains rate is approximately 12% less than regular income tax rates. Employees may have to pay an alternative minimum tax (AMT) if they exercise their options after they’ve increased in value but before they’re liquid.

What Are the Voting Rights and Dividends Differences? (Needs further check with legal..)

As we continue to explore restricted stock units vs. stock options, another significant difference between them pertains to the holders’ voting rights and whether holders are entitled to dividends.

Concerning stock options, it’s pretty straightforward. Let’s revisit the definition of a stock option. Essentially, it’s a contract to buy or sell a certain number of shares of your company’s stock at a certain price for a designated timeframe. Holding a stock option isn’t the same as owning it. So, employees would have no voting rights and no rights to dividends either. Employees will only receive dividends when they exercise their options and take ownership of the underlying shares. At that point, they become true shareholders and retain full voting rights.

With RSUs, voting rights work differently. Employees’ voting rights are very limited with RSUs. The only time RSU holders get voting rights is when their RSUs are actually paid out and converted into common shares. RSUs don’t pay dividends before being converted into shares.

Deciding Between Offering Stock Options or RSUs Based on Company Stage

A comparison of RSU vs. stock options isn’t complete without considering which choice is more appropriate than the other based on your company’s stage of growth and maturity.

Let’s start with a look at whether stock options might be the best choice for your company’s stage of development. Startups commonly grant restricted stock to founders and initial employees. As the company grows and the company’s common stock value begins to rise, it’s common for companies to offer stock options as a form of equity compensation. Stock options tend to be good choices for early-stage, high-growth startups where stocks are likely to increase in value quickly.

Be aware that you’re obligated to collect or withhold income and employment taxes on exercise, and you’ll need to have people and processes in place to ensure it gets done, which may be difficult for a startup. The failure to withhold taxes can result in penalties for individuals within the company or the company itself.

It’s less common for startups in the early-stage to grant RSUs. If you choose this route, you’ll have to have sufficient cash reserves to fund the taxes due on settlement. The other option is to postpone vesting until you can be sure there is enough cash to fund the taxes. Once your company has a reliable income stream, RSUs are less risky, making more sense. Mature, highly valued companies tend to offer RSUs when the fair market value of the common stock is too high to motivate employees to buy stock options.

11 Key Takeaways

To wrap things up, we’ve put together 11 key takeaways for you to consider:

  1. Stock options and RSUs are valuable incentives for acquiring and retaining top talent.
  2. With stock options, the price is determined at the time of issue, and employees will be able to buy shares at a certain time.
  3. RSUs don’t require employees to make a payment upfront, and they often include a vesting period.
  4. With stock options, the exercise price is based on the full market value of underlying security.
  5. Stock options are paid in stocks, while RSUs are paid in stocks or cash.
  6. RSUs are taxed upon vesting.
  7. With stock options, employees have the ability to time taxation.
  8. Stock options are typically better for early-stage, high-growth startups.
  9. RSUs are generally more common for companies that are late-stage and/or have liquid stock.

Choosing between stock options vs. restricted stock units is just one of many decisions you need to make as you prepare for the pre-IPO stage. Get your company off to a good start by valuing your company accurately and following best practices for good governance — two things that go hand-in-hand. We’ve got help for you on both accounts.

With Diligent Equity software, you can easily manage the administration of your stock options or RSUs, manage your cap tables, model rounds and assess dilution.

Poor governance has been the demise of many IPOs. To help you understand the benefits of placing a strong focus on good governance, we’ve put together a white paper called The Governance Gap that covers three stages of governance, including:

  1. Equity governance
  2. Board governance
  3. Operational governance

Check out The Governance Gap to learn more about why good governance is critical for early-stage companies and how it can position your company to be acquired or IPO.

 

This post is not intended to provide legal, tax or financial advice. Always consult with an attorney,  financial advisor, accountant and/or other professional.

 

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