The merits of Stock Options vs RSUs depends on whose perspective you have, the employee or the employer (company issuing the equity), and the stage of the company. Stock Options are usually better for both at an early stage company. For a later stage company, RSUs are usually better for both. The fundamental difference between the two is that a stock option grant allows the optionee to purchase stock after vesting but at a fixed price whereas 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.
Pros and Cons of Stock Options
Stock Option Pros:
- The employee can get more shares and the strike price is small so that the difference in value with one RSU is negligible.
- A stock option can be turned into a share that can be sold while the company is still private. This usually requires permission but it can be done whereas an RSU cannot be transferred at all.
- A stock option can be exercised at almost any time to qualify for reduced taxes via Long Term Capital Gains or no taxes through Qualified Small Business Stock.
- 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 taxes for RSUs.
- The exercise price and associated taxes 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.
- 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. During the RSU-phase, companies are motivated to have the FMV rise.
- If an employee exercises, the company actually gets cash. If the employee pays taxes on options, the company gets a tax deduction.
Stock Option Cons:
- As the FMV rises, the high exercise price isn’t attractive for hiring new employees. Especially if they are concerned about having to leave and pay the high exercise price in order to retain the shares.
- 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 exercising.
- Options typically expire within 90 days of leaving a company. However, NSOs can have a longer expiration and ISOs can easily flip to NSOs if the company wishes to do so.
- Until an optionee finally recognizes the income tax on a stock option, the company does 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.
- A stock option can be under water and worthless if the FMV is below the exercise price. Since options are initially granted at the FMV, recipients are often unsure of the value. As such, they focus on percentage ownership instead which is an unsustainable model for companies.
For more information on how to monetize your private company equity, please contact us at the Employee Stock Option Fund.