Stock Options vs. RSU: Which Equity Compensation is for You?

Upstock Team

June 1, 2023

Stock Options vs. RSU: Which Equity Compensation is for You?

June 19, 2023

Stock Options vs. RSU: Which Equity Compensation is for You?

Are you interested in using employee equity compensation for your company? You might want to consider either stock options or restricted stock units (RSUs).

Restricted stock units and stock options are two of the more popular types of employee equity compensation. Choosing between stock options vs. RSU will depend on a few factors, such as each type’s benefits and disadvantages, the stage of the company’s growth, and the preferences of the employees and shareholders. 

Let us walk you through all the things you need to know.

Read More:

Stock Options vs. RSU: Which is Better For Your Company?

Restricted Stock Units (RSUs) are the best worker equity

What are Stock Options? 

Stock options is a type of equity compensation that allows employees to purchase company stock at a predetermined price, which is called the strike price or exercise price. The strike price or exercise price is usually set at the fair market value of the company’s stock at the time the option is made available.

Stock options usually have a minimum time requirement called a vesting period that employees must reach before being eligible to buy. The typical vesting period is 3-5 years.

Stock options have several types, but two of the most common ones are incentive stock options (ISOs) and non-qualified stock options (NSOs). This type of equity compensation is commonly used by early stage startups and publicly held companies.

How Do Stock Options Work?

Although this type of equity compensation plan grants employees the right to purchase stock, they can’t do so right away. Employees need to reach the required vesting period before becoming eligible to exercise options.

For instance, if the employee compensation plan grants an employee options with a five-year vesting period, an employee must stay within the company for the entire predetermined vesting period of five years before they can exercise their options to buy company shares. Once the employee has done this, they can gain full ownership of the shares of company stock units.

However, if the company is private, the purchased stock will likely be restricted. This means the employee will not be allowed to sell the shares without the company’s approval. But if the company is public, the stock will generally not be restricted after the company reaches an IPO.

Incentive Stock Options and Non-Qualified Stock Options

Incentive stock options, as the name suggests, are given to employees as an incentive to help the company succeed. Companies usually offer shares at a discounted price, so employees have a chance to own company stock if they exercise the granted options.

Once they have purchased stock units, they will be motivated to work hard. After all, they will share in the success of the business.

Aside from a discounted price, ISOs also benefit from tax advantages, provided that certain criteria are met. If the employee holds the stock for a minimum of two years from the date of the grant and at least a year from the date of exercise, any gains from the sale of the stock are taxed as long-term capital gains and not as ordinary income. This can mean significant tax savings for both the employee and the company.

On the other hand, NSOs are simpler and have more relaxed requirements than ISOs. In fact, they are called “non-qualified” because they lack some criteria for them to qualify as ISOs.

NSOs don’t have the same tax benefits as ISOs. Any profit from the sale of purchased stock will be taxed as income, even if the employee held the stock for years before selling.

What are the Benefits of Offering Stock Options?

Here are some of the benefits of stock options:

  • Powerful incentive: Stock options require the employee to essentially stake a specific sum of money for the strike price. This can promote loyalty and align the interests of employees with the company as they will have “a slice of the pie.”
  • Extra cash flow: For employees, stock options provide another source of income. If a company's stock price goes up, those granted options can sell shares at a profit.
  • Can attract and retain valuable employees: When used correctly, this form of employee equity compensation can be a valuable way to attract top performers, especially in a tight market.

What are the Drawbacks of Stock Options?

On the other hand, here are some of the disadvantages of stock options:

  • Volatility: While stock options can be valuable for attracting and retaining employees, they can also have drawbacks. One of the biggest potential problems with this type of equity compensation is that employees can lose money if the value of the stock falls down below its exercise or strike price.
  • Might be difficult to understand: Because of the many tax implications, stock options can be complicated and expensive to administer, too. Employees who are unfamiliar with tax laws might shy away from joining. 
  • Forfeiture: Because stock options generally have an expiration date, employees might miss the opportunity to exercise their options. Employees who leave the company before completing the vesting period will also forfeit their stock options.
  • Dilution: Lastly, issuing stock options can lower the value of shares because stock ownership will become diluted.

What are Restricted Stock Units?

If stock options give employees the right to purchase company shares after a pre-set time, restricted stock units grant employees (or contractors, advisers and other stakeholders) the right to receive company shares when certain restrictions or vesting requirements are met.

RSUs, like the name suggests, are restricted units, meaning the employee cannot dispose, sell, or transfer the shares until certain conditions are met. However, once vested and fully delivered, employees can opt to sell shares. Any profit from the sale will be subject to capital gains tax.

RSUs have two types: single trigger RSUs, and double-trigger RSUs. Private companies in particular prefer double-trigger RSUs over single-trigger as they have much better tax implications for the employees. 

How Do Single Trigger and Double-Trigger RSUs Work?

If stock options have a fixed, time-based vesting schedule, RSUs have one or two milestone-based vesting triggers. Once this trigger or triggers are met, the RSU is considered vested and will be delivered to the employee.

Single trigger RSUs vest on a single trigger milestone or event, such as a company merger or acquisition. Double-trigger RSUs vest on two events, such as an acquisition or an IPO and hitting a revenue goal within a certain timeframe.

RSU triggers vary depending on the terms of the company. Some companies may use time-based single triggers similar to a stock option’s vesting schedule.

What are the Benefits of RSUs? 

Here are some of the benefits of RSUs:

  • Less risky: RSUs don’t require employees to purchase shares, making them less risky than stock options. Employees receive the shares the moment they vest.
  • Alignment of interests: On the side of the employer, RSUs can also help in creating a sense of loyalty among employees as they want to see the value of their shares increase.
  • Ease of use: Administration cost is another massive benefit of offering RSUs to employees. There isn't any actual stock or share that needs to be recorded or tracked.
  • Delayed dilution: Employers can defer share issuance until the completion of the vesting schedule or the occurrence of landmark events. As a result, the possible dilution of shares is delayed. 

Take note: dilution of shares from granting restricted stock options to employees can be avoided with issuance of non-voting interests.

What are the Drawbacks of RSUs?

The common drawbacks of RSUs are as follows:

  • No dividends: RSUs don’t have dividend payments until the shares are actually delivered. This might turn off employees who expect regular cash flow from their equity compensation.
  • No voting rights: Shares from RSUs don't come with voting rights, which means employees have no say when it comes to the company’s decision-making. However, this may be an upside for some companies.
  • Longer vesting time: Double-trigger RSUs in particular often take a longer time to vest and be settled. And because RSUs are taxed the moment they vest, employees may not have control over the timing of taxation.

What are the Key Differences Between Stock Options vs. RSU?

Stock options and RSUs are both employee compensation benefits that give the recipient the right to buy or receive company shares at a future time. However, there are key differences you need to consider, such as:

  • Exercise price: There's none set for single- and double-trigger RSUs. For stock options, however, the exercise price can be based on their fair market value or some nominal price.
  • Vesting: For stock options, vesting is often a fixed, time-based affair. Still, it’s possible for their vesting to be tied to specific milestones.

Restricted stock units are more flexible. They can be awarded on a performance benchmark, predetermined vesting schedule, or both.

  • Valuation: The value of stock options depends on the stock price at the time of exercise. The value of RSUs is based on the fair market value of the stock at the time of vesting.
  • Risk: Stock options are riskier than RSUs. If the stock price plummets below the exercise price, the options’ value can go down to zero. With RSUs, employees are guaranteed to acquire shares of the company's stock as long as they fulfill the vesting requirements.
  • Grant: The most crucial difference between the two types of employee equity compensation is what’s actually received by the recipient. For stock options, the recipient gets the option to buy or sell company stock at a predetermined price. For RSUs, the shares are granted themselves upon the completion of the vesting requirements and/or achievement of key milestones.

Stock Options vs. RSU: Which is Better?

Choosing between stock options vs. RSU depends on your unique circumstances and priorities. Some experts say that stock options are best for publicly held companies. However, there’s also the risk that the stock price will drop below the set price, meaning you could lose money. 

Restricted stock units, particularly double-trigger RSUs, offer a more predictable return. There’s no worry about the value of the stock going “underwater.” As long as the stock’s value is more than zero, a positive return can be obtained. Experts believe that double-trigger RSUs are the best employee equity compensation among private companies. 

The decision between stock options or RSUs comes down to your financial goals and risk tolerance.

Streamlining Employee Equity Compensation with Upstock

At Upstock, we help forward-thinking companies deploy state-of-the-art equity plans. We also help communicate to your employees the details of the equity plan and their particular offer. This includes when they're likely to receive a payout of the award, and what the company needs to get there. 

Upstock does this through intuitive and inspiring dashboards, educational materials, and informational explainers. Our plans are available in over 70 countries. 

With Upstock, you can ensure your employees are aligned with your interests regardless of where they're located around the world. We can provide you with general information on RSUs and what experts are saying about it as well.

If you’re still unsure of what’s best for you, we have some thoughts on this topic that could help you decide. Let’s discuss and get on a call by clicking here.

Disclaimer: This material has been prepared for informational or education purposes only. The discussions or information contained herein is based on sources reasonably  believed to be reliable but which has not been independently verified by Upstock or an independent tax or legal professional. Thus, it is not intended to provide, and should not be relied upon for tax, investment, business and/or legal advice. Please consult with your own tax or investment adviser and legal counsel regarding this subject matter especially with respect to the relevance or accuracy of any discussion or information contained in this material under the applicable laws, rules and regulations in your jurisdiction.

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