Compare stock options and RSUs in our comprehensive guide to determine which employee equity plan best suits your company’s needs.

Introduction

Employee equity plans are pivotal in attracting and retaining top talent, especially in startups and rapidly growing companies. Among the various options available, Stock Options and Restricted Stock Units (RSUs) are the most prevalent. Understanding the nuances between these two can help both employers and employees make informed decisions that align with their financial goals and company objectives. This guide delves into the core aspects of each equity plan, highlighting their differences, benefits, and suitability for different business stages.

What are Stock Options?

Stock Options grant employees the right to purchase company shares at a predetermined price, known as the exercise price or strike price, at a future date. Typically, this price is set to the fair market value (FMV) of the company’s stock at the time the option is granted. Stock options are usually subject to a vesting period, meaning employees earn the right to exercise their options over time or upon meeting specific milestones. This mechanism incentivizes employees to contribute to the company’s growth, as the value of their options increases with the company’s stock performance.

There are two primary types of stock options:

Incentive Stock Options (ISOs): Reserved exclusively for employees, ISOs may offer favorable tax treatment, allowing employees to pay only capital gains tax upon sale, provided certain conditions are met.
Non-Qualified Stock Options (NSOs): Available to a broader group including contractors and directors, NSOs require holders to pay ordinary income tax on the difference between the exercise price and the FMV at the time of exercise.

Typical Life Cycle: Grant ➜ Vesting ➜ Exercise ➜ Sale

What are Restricted Stock Units (RSUs)?

Restricted Stock Units (RSUs) represent a promise to deliver company shares or their cash equivalent to employees once certain conditions, such as vesting periods or performance targets, are fulfilled. Unlike stock options, RSUs do not require employees to purchase shares; the shares are granted outright upon vesting. This eliminates the need for upfront payment, making RSUs less risky for employees.

Upon vesting, RSUs become taxable as ordinary income based on the FMV of the shares at that time. Employees can then choose to hold or sell the shares, potentially benefiting from any increase in stock value. RSUs are particularly attractive in established companies where stock prices are already substantial, ensuring that the granted shares hold inherent value.

Typical Life Cycle: Grant ➜ Vesting ➜ Receive Shares ➜ Sale

Key Differences Between Stock Options and RSUs

While both stock options and RSUs serve as long-term incentives to boost employee engagement and company value, they differ in several critical aspects:

1. Value of the Shares

Stock Options: The value hinges on the stock price rising above the exercise price. If the company’s stock appreciates significantly, the options can yield substantial profits. However, if the stock price remains below the strike price, the options may expire worthless.
RSUs: RSUs always hold some value as long as the company’s FMV is above zero. They provide guaranteed value without requiring the stock price to increase, making them inherently less risky than stock options.

2. Need to Pay for the Stock

Stock Options: Employees must pay the exercise price to purchase the stock, which can be a financial burden if the stock’s FMV is significantly higher than the strike price.
RSUs: No payment is required from employees. Shares are granted automatically upon vesting, simplifying the process and reducing financial risk.

3. Tax Treatment

RSUs: Taxed as ordinary income upon vesting based on the FMV of the shares. Any subsequent gains from holding the shares are subject to capital gains tax.
NSOs: Taxed as ordinary income at exercise on the spread between the exercise price and the FMV. Additional capital gains taxes apply upon the sale of the shares.
ISOs: May qualify for capital gains tax on sale if specific holding periods are met, but can trigger Alternative Minimum Tax (AMT) during exercise.

4. Ability to Time the Tax

RSUs: Employees have no control over the timing of tax obligations, as taxation occurs automatically upon vesting.
Stock Options: Offer flexibility in timing tax events, allowing employees to choose when to exercise options based on their financial situation and tax planning.

Which Is Better?

The choice between stock options and RSUs depends on various factors, including the company’s stage, financial health, and employee preferences:

Stock Options: Ideal for startups and early-stage companies anticipating rapid growth. They offer the potential for significant financial gains if the company’s stock appreciates. However, they carry the risk of becoming worthless if the company’s performance falters.
RSUs: Suited for established companies with stable stock prices. They provide guaranteed value and are less risky, making them attractive for senior employees and executives. RSUs also simplify the equity compensation process by eliminating the need for employees to invest upfront.

Summary

Feature	RSUs	Stock Options
Value Basis	FMV of stock	Stock price appreciation above exercise price
Risk Level	Lower, always have some value	Higher, can become worthless if stock price declines
Payment Requirement	No payment needed	Requires payment to exercise
Tax Complexity	Simpler, taxed at vesting	More complex, especially ISOs with AMT considerations
Control Over Tax Timing	No control	Yes, can choose when to exercise
Suitability	Established and public companies	Startups and high-growth companies

Choosing the right employee equity plan involves assessing your company’s growth trajectory, financial stability, and the preferences of your workforce. Both RSUs and stock options have unique advantages that can align with different business strategies and employee expectations.

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