Traditionally thought of as a way to attract and retain executives, equity compensation has become increasingly popular for individual contributor roles. Restricted stock units, or RSUs, are more common with publicly traded companies while stock options are frequently granted in early-stage private companies. In my work with tech employees, I’ve seen some companies offer a choice between RSUs and stock options. Equity compensation is already confusing to most employees, and the addition of this choice adds even more complexity. In this blog, I offer suggestions on what factors to consider in making this decision.
RSUs vs. Stock Options
A stock option is the right to buy shares of company stock for a fixed price (known as the exercise or strike price) during a fixed period (usually 10 years). Stock options are subject to vesting, which is the time you must wait before you can exercise your options. There are two types of stock options, non-qualified stock options and incentive stock options, and they differ in tax treatment.
A restricted stock unit is your company’s promise to give you shares of stock in the company as soon as you meet certain requirements. The most common condition is time with the company, but it could also be certain performance metrics determined by your company. For this article, I will only reference the condition of time for vesting and non-qualified stock options and RSUs in publicly traded companies.
There are a few key differences between RSUs and stock options:
- The value of a stock option is determined by the difference between the exercise price and the stock’s current value. If the stock’s current price is above the exercise price, the stock option has value, commonly known as “in the money.” If the stock’s current price is below the exercise price, the stock option has no value. RSUs always have value as long as the company stock has value. As a result, the risk is higher with stock options versus RSUs.
- With stock options, you pay the exercise price to buy the shares. Some companies allow for a cashless exercise where you exercise and sell the shares at the same. The proceeds are used to cover the cost of exercise and you receive the balance. In either case, the difference between the stock’s current value and the exercise price is taxable at the time of exercise. In other words, you control the timing of the taxation with stock options based on the time you exercise them. With RSUs, no payment is needed to receive the shares. As soon as the shares vest, they are taxable as ordinary income.
- Once RSUs vest, you will have to decide when to sell the stock. Once stock options vest, you will have to decide when to exercise the shares. Unless you opt for a cashless exercise, you will also need to decide when to sell the stock.
Like many financial decisions, choosing between RSUs and stock options requires more than a numerical calculation. Start by gathering important information that can help you make an informed decision. I like to think about the considerations in two categories: objective and subjective.
These questions can help you determine the financial implications of choosing between RSUs and stock options.
- How many stock options will you receive for each RSU? Because the risk is higher with stock options than with RSUs, companies typically offer more stock option grants in exchange for RSU grants. An offer could come in the form of a fixed ratio – like three stock options for every one RSU – or your company could use an internal calculation.
- Is the decision all or nothing, or can you choose a mix of the two? Many companies allow you to choose in 25% increments. For example, you could select all stock options, all RSUs, or some combination (like 25% stock options and 75% RSUs).
- What is the exercise price for the options? Typically, the exercise price of a stock option is the value of the stock at the date of grant. If your company uses an internal calculation instead of a fixed ratio, the exercise price for stock options may be adjusted accordingly.
- Will you receive additional grants in the future? If you receive equity grants regularly, you’ll have the opportunity to change your mind or “course correct” with future equity grants.
- What happens to your stock options if you leave the company or retire? Each company’s plan is subject to its own rules. With RSUs, it’s common to lose unvested RSUs if you leave the company or retire. Generally, when you leave a company (whether voluntarily or to retire), you have up to 90 days from your date of termination to exercise any vested stock options. Some company plans provide more favorable terms for retirees.
These questions are more personal in nature and can help you determine if stock options or RSUs are better for your situation.
- What’s your current financial situation and life stage?
- What are your financial goals? Are you on track to reach your goals?
- Could the equity compensation grant you’re receiving help fund your goals?
- What is your risk tolerance?
- Do you anticipate any job or life changes? Are you close to retirement?
How Do You Choose Between the Two?
There is no right answer when choosing between RSUs and stock options. The decision will vary from person to person and could vary from year to year as your situation changes. If you’re a young professional with financial goals that require immediate cash, RSUs can provide predictable income and are likely a better choice. Maybe you’re planning to retire soon, and your company plan offers more favorable terms for stock options than RSUs. If the amount of equity you’re considering is not significant relative to your retirement nest egg and you’re comfortable with the additional risk, stock options could be the better choice.
When deciding between RSUs and stock options, start by gathering both objective and subjective information. From there, consider your personal goals, life stage and risk tolerance. Equity compensation is complex, so don’t be afraid to ask for help. A financial planner and tax professional can help you understand your options so you can decide what’s best for you.
When it comes to choosing between RSUs and Stock Options, there’s a lot to consider. Need help deciding? Let’s have a conversation!
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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Chloe Moore, and all rights are reserved. Read the full disclaimer here.