Restricted stock units (RSUs) and stock options are some of the common types of employee equity compensation. When considering the best choice for your company, it's necessary to note the key differences between company stock options vs RSUs.
To help you make an informed decision on employee equity, we've created a guide on everything you need to know about RSUs and stock options.
What are Stock Options?
Stock options allow employees to buy stock in their company at a pre-set or discounted price. This means that employees must stay with their employer for a certain time (pre-determined vesting period) to exercise their options and purchase company shares.
Stock options, commonly distributed to employees of publicly held companies, “vest” or become exercisable typically in a span of 3-5 years.
A stock option as equity compensation can generate significant returns but may also carry some risks. If the stock market price falls, employees end up losing money. For this reason, it's essential to understand the pros and cons of stock options before deciding whether to accept them as part of the compensation package.
Value of Employee Stock Options
The value of employee stock options at the vesting date will depend on the options' strike price and performance of the company stock. The payoff of the recipient rises by a dollar for each dollar the company stock price goes above the exercise price. If the company stock price falls below the exercise price when the stock options vest and they are left unexercised, then the recipient or employee won't have any payoff.
What are Restricted Stock Units (RSUs)?
A restricted stock unit grants employees the right to receive shares when certain restrictions or vesting requirements are met. They are typically offered by private companies for several reasons, including the advantage of deferred tax payments until a landmark event occurs.
RSUs can have either a single- or double-trigger vesting schedule. Public companies typically issue single-trigger RSUs, while private companies grant double trigger or "pre-IPO" RSUs.
Key Points on RSUs:
- Single trigger RSUs are typically awarded by publicly traded companies and commonly vest monthly for 4 years with a 1-year cliff.
- Double-trigger RSUs have both a worker performance trigger and a company performance trigger. The worker must provide services for the company during a set amount of time, and the company must reach a liquidity event like an IPO or acquisition.
RSUs are often used as a form of long-term incentive or compensation. The value of an employee's vested RSUs will depend on the RSU agreement between the employer and the employee. The legal document explains what every unit awarded is worth. Every unit is typically equivalent to one share or some other similar unit of ownership interest in the company.
How Do Stock Options Work?
Stock options give the holder the right in buying or selling shares of a company at a pre set price or a certain period of time. The employee can then hold on to the shares or sell them for a profit. Incentive and non-qualified stock options can attract and retain talent, but they can also be complex and risky.
How Do RSUs Work?
RSUs grant the right to receive shares or units of ownership in the company. The employee does not yet own them until they fully vest. RSUs are "restricted" until certain conditions are met. For single-trigger RSUs, this can be reaching a specific date being employed by a company or achieving a performance goal.
RSUs with multiple triggers, on the other hand, require different events to be achieved before the shares are granted. Typically, there is a time or performance goal which the worker is responsible for and also a company performance goal that is a liquidity event. Once the RSUs vest, the employee receives the shares of stock.
What are the Key Differences Between RSUs vs Stock Options?
Stock options and RSUs are both employee compensation benefits. With a stock option, it gives the recipient the right to purchase stock, while RSUs are awarded for the recipient to receive shares at a future time.
There are important distinctions between the two, such as their exercise price, tax treatment, vesting, and impact on the capitalization or cap table.
- Exercise price - workers would have to buy the stock options at the exercise price. This presents an issue for the workers who will be required to come up with the money to purchase the shares. As employees don't know if the company will succeed, they may end up paying money for the options which carry the risk of going underwater or having no value. For RSUs, there is no exercise price. This means workers don't have as much risk to mitigate, and the equity is usually more motivating.
- Vesting - For both RSU and stock options, vesting can be tied to a period of time or specific milestones. However, with stock options, workers will forfeit their equity if they leave the company unless the company takes specific action to award non-qualified stock options (NSOs) after a worker departs. Pre-IPO RSUs, on the other hand, can continue to be vested and awarded to workers, even after they leave the company and a liquidity event hasn't been reached yet, in the case of a private company.
- Tax implications - Paying taxes for stock options can be incredibly overwhelming. For NSOs, capital gains tax is to be settled if the shares are sold at a profit. When the sale of shares has resulted in a loss, capital loss has to be reported for the difference of the employee's tax basis and what's received. With incentive stock options that are sold immediately upon vesting, the ordinary income tax rate must be paid in order to lock in the gains immediately. Double-trigger RSUs are a lot less complicated because the worker only pays tax if and when a company reaches a liquidity event.
- Effect on Cap Table - with stock options, workers have to buy their equity by exercising the grant. When a worker receives stock in this way, they will be placed on the cap table and have shareholder voting rights. This can complicate the impact of employee equity compensation on the company and create overhead and legal expenses. On the other hand, a double trigger RSU is a promise for future equity. Workers don't show up on the cap table and obtain shareholder rights, as opposed to stock options. This is simpler and carries less risk.
What are the Benefits of Offering Company Stock Options?
Many companies offer employees stock options to incentivize and reward them for their work. While there are some risks associated with stock options, there are certain circumstances where companies may want to offer stock options to key employees in the earliest days of the company.
Double trigger RSUs generally reduce overhead, cost and legal complexity. Many workers do not want to spend the extra time and hassle dealing with these challenges which can, in some circumstances, minimize tax liability. Stock options are challenging for companies to issue as they can't be easily granted globally, across multiple countries.
What are the Drawbacks of Company Stock Options?
While incentive stock options can be valuable for attracting and retaining employees, they have drawbacks. One of the biggest potential problems with stock options is that employees can lose money if the value of the stock falls below its exercise or strike price. What's more, workers will be added to the cap table, creating excess legal complexity.
Both non-qualified and incentive stock options can be complicated and expensive to administer, too, as mentioned earlier. This can put a strain on a company's finances. It’s important to weigh the pros and cons of stock options before deciding whether or not to use them.
What are The Benefits of RSUs?
For employees, RSUs can lead to big payouts. If the company does well, the value of the shares will increase. The employees will be able to sell them at a higher price. 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.
Let's take a more in-depth look at the many benefits of RSUs, particularly double-trigger RSUs, which both the employer and the employee can enjoy.
Less Administrative Costs
Reduced administration cost is an important benefit of offering employees restricted stock units with a double trigger vesting schedule. RSUs are a promise for future equity and from a reporting perspective, they are not considered stock or shares which come with a variety of complexities. Employers can defer share issuance until the completion of the vesting schedule or the occurrence of a landmark event. As a result, technically speaking, the dilution of shares is on the company cap table is delayed.
Double-trigger RSUs can be an attractive choice for employees because they won't have to pay taxes until if and when the vesting requirements have been met. Generally, regular income tax rates (ordinary income tax rates) apply to RSUs when they vest and become restricted stock awards. On the other hand, incentive stock options are generally purchased by employees with funds that have already been taxed.
No Immediate Effect on the Cap Table
RSUs are helpful to most private companies because they don’t have an immediate effect on the cap table. Until the double trigger RSUs fully vest, they are essentially an unfunded contract to compensate an employee in the future. The recipient of double-trigger RSUs will not have any voting rights or rights to dividends when companies pay out profits.
They Don't Go "Underwater"
Compared to other types of employee equity compensation e.g. stock options, double-trigger RSUs are different as they always have value unless a company's stock market price goes to $0. Only when they become fully vested are they assigned value. It is typically based on the fair market value of the underlying stock.
Workers don't have to buy them
There's a transfer of ownership typically involved when double-trigger RSUs fully vest. This means recipients of double-trigger RSUs don't need to buy shares of the company. As opposed to RSUs, stock options require workers to purchase the shares themselves, using their own money, at the exercise price. Stock option holders can only profit when shares are sold at a higher market price. Finally, workers have a maximum of 7 years in which to buy their options because at that point, the 409A valuation will expire.
Vesting continues even after employees leave
With other forms of equity compensation, vesting halts if an employee leaves or is terminated. With double trigger RSUs, vesting may continue even in cases of death, retirement or disability. This is typically controlled by the RSU agreement.
Alignment of Employee-Employer Interests
More importantly, RSUs with performance triggers as a form of employee equity compensation align employee and shareholder interests. They are easier for workers to understand as opposed to stock options. Offering double-trigger or pre-IPO RSUs is arguably one of the best ways for private companies to attract, retain, and motivate highly valued employees, regardless of where the employees are based or located around the globe.
What are the Drawbacks of RSUs?
The common drawbacks of RSUs are as follows:
- RSUs don't offer dividends;
- RSUs don't provide employees voting rights (an upside to some companies); and
- RSUs often take a longer time to vest and be settled.
These drawbacks are considered upsides to some, depending on the goal or interest of either the company or the recipient.
RSUs vs Stock Options' Fair Market Value: Which is Better?
If you are a public company and your budget is not in question, you can issue stock options or RSUS, depending on your strategy. If you are a private company, you may want to issue stock options in the earliest days of the company, wherein the stock price is extremely low or close to zero. Many companies issue RSAs instead of options at the earliest stages. See Steve Blank's great article on this: https://steveblank.com/2019/04/10/startup-stock-options-why-a-good-deal-has-gone-bad/
As the company's global footprint and teams expand, it can be hard to issue stock options in a way that is both realistic and practical. This is why companies quickly move to using double-trigger restricted stock units because they work similarly in over 75 countries.
Choose Upstock to Deploy Employee Equity Compensation
A strong equity package consisting of RSUs can be quite beneficial for your business. You'll be in a better position to compete for the most sought-after candidates in the talent pool if you offer them a stake in the company they'll help establish.
More importantly, giving employee equity can ignite a true, unique sense of ownership. That is what you need to ensure the whole team rallies around your company mission. It starts with each employee’s equity stake in your company.
Here’s what Tuvens CEO, Ciaran Carrol, has to say about offering restricted stock awards with Upstock:
"I am now onto my 2nd venture with Upstock. Started my previous tech company with an idea, a dream, and almost ZERO capital. Upstock’s equity-as-a-service and simplification of the process of granting restricted stock units helped me grow my top performing team to 25 contributors - all TOP talent from Amazon, Inspire Health, Sutter Health, and IBM Watson.”
With equity as part of the compensation package, The CEO of Tuvens has found that the company enjoys an increase in productivity, longevity, and profitability, especially compared to legacy solutions. This is achieved as employees are motivated to take a more active role in ensuring the success of the company. Creating an ownership mindset makes everyone feel they’re responsible for the company’s highs and lows. It helps build commitment, results in a dramatic increase in alignment with company interests, as well as boosts retention rate up to 300%!
At Upstock, we help private companies in 75 countries (and growing) deploy state-of-the-art equity plans. Imagine what it would be like if you hire and inspire the best workers from across the globe to provide you with maximum engagement and help realize your vision and mission, ultimately ensuring your company’s growth and success. Upstock turbocharges companies every day to do this.
We can help you get started! Book a demo today by clicking here.
Disclaimer: This material has been prepared for informational or educational purposes only. The discussions or information contained herein are based on sources reasonably believed to be reliable but which have 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 financial advisor 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.