When joining a new company, you may not just be offered a flat salary. As companies are looking for ways to lure in top talent, management is increasingly offering perks such as executive compensation benefits to incoming employees. Often times, these benefits come in the form of Restricted Stock Units (RSUs) or Stock Options. However, understanding what these benefits entail and how they stack up against one another can be confusing at first. To get a better grasp on what your company may be offering you, here are some important things to know.
The Basics:
Stock options give you, the employee, the right, but not the obligation, to buy equity in your company at a predetermined price (also known as the grant price) sometime in the future. The value generated from your options are derived from the difference between the previously agreed upon buying price and the actual price per share at the time of exercise. To provide further clarity, assume you are offered stock options that allow you to buy 1,000 shares of equity in your company at $10 per share. If in a year, the stock price of the company is $13 per share, that stock option will be worth $3,000 (1,000 shares multiplied by the $3 difference between the agreed upon price and the current market value). However, if the stock price of your company falls below the agreed upon price, say $9, this option will be “out of the money” or worthless for the time being. You have until the expiration date of the option to exercise, so the value of the stock option will fluctuate along with the stock price. Simply put, your stock option allows you to benefit from the growth in value of your company.
Restricted Stock Units (RSUs) provide similar benefits to that of stock options – allowing you to grow with the company – but are constructed somewhat differently. RSUs represent a commitment by your employer to provide you with equity in the company or the cash equivalent so long as you reach predefined milestones. These milestones are usually laid out through a vesting schedule and can be based on performance, time spent at the company, or a combination of both. As each milestone is reached the RSUs are said to have “vested,” entitling you to receive a specified number of shares or cash. For instance, say you are offered 1,000 RSUs with the ability to receive 25% of the total RSUs for each year you work with the company, up to four years. Based on the vesting schedule, at the end of each year you will receive 250 RSUs which are then redeemable for shares in the company. As it will be explained later on, the redeemable RSUs may be deferred for tax purposes, to a certain extent. Unlike stock options, RSUs do not cost you money in order to receive the benefit; thus, this allows RSUs to nearly always be worth something, even if the company loses value.
Tax Implications:
The major difference between RSUs and stock options is the way in which they are taxed. Typically, the federal government taxes vesting securities, and thus RSUs are subject to taxation as soon as they become vested. In such cases, your RSUs will be taxed at the ordinary income rate and may also be subject to capital gains tax on any subsequent gains; short-term capital gains tax will be incurred if sold within a year and long-term capital gains tax will be incurred if sold after holding for over a year. However, under certain pre-agreed upon conditions, some RSUs are designed such that you can defer your tax payment to a date later than when it originally vested. While a tax payment will still be made, this contractual term of an RSU can allow for a delay in payment and may be advantageous to some.
On the other hand, stock options provide more attractive tax treatment as they are not taxed until you exercise them. Given that these options can be exercised at your discretion (up until their expiration date), you are essentially controlling when you want to incur income and therefore taxes. However, stock options do come in two forms, incentive stock options (ISOs) and non-qualified stock option (NSOs), which carry varying tax implications. For NSOs, you are taxed at the ordinary income rate on the difference between the market price and the price you were granted. This difference also results in you incurring payroll taxes such as Social Security and Medicare at the time of exercise. In contrast, ISOs may allow you to bypass payroll taxes – though you may be subject to the alternative minimum tax (AMT). To simplify the understanding of how ISOs are affected by taxes, first consider the time frame following the time of exercise. If, within a year of exercising, you elect to sell the underlying shares of your company, you will be subject to taxation at your ordinary income rate on the difference between the market price and the price you were granted (similar to NSOs). Meanwhile, upon exercising and holding (rather than selling) the underlying shares, you are subject to the alternative minimum tax. Finally, the IRS states that ISOs may be treated as equity interest and not income in so long as you hold the underlying shares for at least one year following exercising and two years from the grant date of your option. This results in you paying the going long-term capital gains rate – as opposed to the ordinary income rate – on the difference between the ISOs market price and grant price. For further information consult with your investment advisor.
Other things to consider:
Further differentiating between RSUs and stock options, the latter gives you both shareholder voting rights and dividend rights upon exercising (but not before). As for RSUs, you are not granted voting rights or dividend rights until the units are vested so long as the vested units are given in the form of stock and not cash. However, some companies pay dividend-equivalent payouts for unvested RSUs. Additionally, with stock options, if you leave or are terminated from your company, you may still be entitled to exercise your options. By contrast, RSUs stop vesting once you are no longer with the company and thus only entitle you to the units that have already vested.
Should you favor one over the other?
There is no question that being offered RSUs or stock options is a valuable perk – it gives you a direct interest in growing your own wealth as you help the company grow. While both stock options and Restricted Stock Units have certain benefits over one another, both provide you with the possibility to be compensated. Knowing your risk tolerance is also an important factor in deciding which benefit plan works best for you as stock options, as opposed to RSUs, tend to have a higher risk-reward ratio. If you would like further insight into executive compensation benefits or would like help navigating your compensation benefits, make sure to reach out to your investment advisor.
Word Key:
- Grant Date: the date you are offered/issued your compensation benefits
- Grant Price (RSU): the base dollar value upon initial issuance of your benefit
- Grant Price (Stock Option): the price at which shares of your company can be purchased when exercising the option
- Vesting Schedule: defines specific milestones, time frames, or a combination of both that when met allow you to exercise predetermined benefits.
