Stock Options Vs. RSUs

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Stock options and restricted stock units (RSUs) are two types of equity compensation that companies offer their employees.

The merits of Stock Options vs RSUs primarily depends on the stage of the company. Stock Options are usually better for both employee and employer at an early stage company. For a later stage company, RSUs are usually better for both.

The fundamental difference is that a Stock Option allows the optionee to purchase stock after vesting while a Restricted Stock Unit is a promise to deliver a share of stock at vesting.

This difference translates to potentially superior tax treatment for stock options because an opportunity to invest exists whereas RSUs are characterized as deferred compensation. Below we will walk through the differences between stock options and RSUs, as well as the pros and cons of each.

Stock Options vs RSUs

Stock Options Restricted Stock Units
Is there a purchase price? Strike price set at company's Fair Market Value. None
How do they vest? Typically on a set vesting schedule Typically on a set vesting schedule. Private companies often include a "double-trigger" that vests when the company exits.
How are they taxed? Taxed when exercised. NSOs treated as income, ISOs taxed with AMT. Taxed when vested as regular income.
What companies typically issue them? Early or mid-stage startups. Late-stage startups (pre-IPO) or public companies.

Stock Option vs RSUs explained:

Pre-IPO sales:
  • Stock options can be turned into shares that can be sold while the company is still private. This usually requires permission.
  • RSUs cannot be transferred at all.
Long Term Capital Gains treatment:
  • A stock option can be exercised at almost any time to qualify for reduced taxes via LTCG (or no taxes through Qualified Small Business Stock).
  • However, exercising can trigger a lot of tax. Small blocks of ISOs can avoid AMT but this benefit is limited by the $100K Limit Rule. NSOs are always subject to immediate withholding tax upon exercise.
  • An RSU must be held for a year beyond vesting to qualify for LTCG when sold. Typically that means one year post-IPO for "double trigger" RSUs.
  • Even after the IPO, a stock option can be retained while still appreciating in value and deferring taxes. On the other hand, an IPO triggers ordinary income taxes for RSUs.
Employee and Employer/Company dynamics:
  • The strike price and associated taxes of Stock Options act as a retention mechanism to discourage employees from leaving the company. Even when exercised early to obtain tax benefits, the effect of having skin in the game better aligns the interests of the employee and company.
  • RSUs lack the retention benefits of options as it is detrimental for companies to grant large blocks of RSUs at an early stage, despite the apparent tax benefits. Employees can simply quit after a year without the golden handcuffs inherent to options, resulting in a diminished option pool for future employees.
  • Rapidly rising FMVs are bad for employee taxes. As such, it is fortunate that companies are motivated to slow down the growth of the 409a FMV while issuing options. As the FMV rises, the high exercise price of stock options isn’t attractive for hiring new employees. Especially if they are concerned about having to leave and pay the high strike price in order to retain the shares.
  • Most late-stage companies turn to RSUs, and during the RSU-phase, companies are motivated to have the FMV rise.
  • If an employee exercises, the company gets cash. If the employee pays taxes on options, the company gets a tax deduction.
  • There is no exercise price for the employee to purchase. They get the whole value of a stock equivalent for free. As such, an RSU is never underwater.
  • A stock option can be underwater and worthless if the FMV is below the exercise price. Since options are initially granted at FMV, recipients are often unsure of the value. As such, they focus on percentage ownership instead, which is an unsustainable model for companies.
  • Companies have a clear sense for how to grant fairly between employees arriving at different times. E.g. a particular job title might budgeted for $100k in RSUs. The number of RSUs to grant would simply be $100k divided by the current FMV.
  • RSUs typically expire within 5 to 7 years and companies are not obligated to reissue them.
  • When employees turn in shares to cover taxes for RSU vesting, the company still has to send real money to the IRS as opposed to shares. This is a very poor use of IPO share selling proceeds that usually has to be disclosed in the IPO prospectus.
  • Until an optionee finally recognizes the income tax on a stock option, the company does so instead. Companies that are concerned with their reported earnings per share won’t like the volatility of their stock price messing up their earnings report.

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This innovative service promotes and enables a healthier relationship between companies and employees. I my opinion it's valuable to employees and great for the overall tech environment and economy. It is good for nobody when employees feel trapped because they can't afford to leave. In less extreme cases exercising can be expensive and somewhat risky and this is simply a good smart hedge and a good square deal. Brilliant!

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