One of the best ways for a company to get its team engaged in building long-term company value is with stock rewards. Giving employees shares of stock incentivizes them to help the company grow its profits and succeed.
However, there are several ways to handle stock grants to employees. Two of the most common are restricted stock units (RSUs) and stock options. Here's a look at RSU vs. stock options to help you understand how they impact your income and portfolio.
The Short Version
- Restricted stock units (RSUs) are shares that employees can earn over time.
- Stock options give the employee the right to buy the shares for a set price on a future date.
- While either stock reward program would be a nice addition to an employment package, RSUs are generally more valuable to employees while stock options provide more flexibility to the employer.
Stock Options vs. RSUs: What Are the Key Differences?
Restricted stock units and stock options both give employees financial exposure to the company's stock. But they work very differently behind the scenes and have different outcomes for the employee.
An RSU is a share of stock that the employee can earn over time. Once fully vested, the employee owns this stock like any other shareholder. They can vote on shareholder proposals, earn dividends and participate in any shareholder meetings or events. The employee has the right to sell the shares at any time, assuming they're not insider trading or in breach of any company rules.
A stock option allows the employee to buy shares of stock at a set price on a future date. If the stock price is above the option price, the stock option is “in the money.” That means the employee can exercise the option to buy shares.
Many people sell the shares at the same time they exercise the option. This locks in an instant profit. However, if the stock price is lower than the option value, the stock is “out of the money” and the options are effectively worthless. Check out our guide to find out more about In the Money vs. Out of the Money.
How Do Restricted Stock Units (RSUs) Work?
With an RSU plan, an employer typically grants RSUs to the employee based on certain conditions. These include working for the company for a length of time or meeting performance objectives.
If the employee accepts the grant and successfully makes it through the vesting requirements, the employee receives the shares of stock or a cash equivalent. Some plans automatically defer receipt of shares to a later date or allow you to defer receipt voluntarily. In either case, once you own the shares, they are yours and unrestricted.
If you have unvested RSUs, you may lose them if you leave the company. With a fully vested RSU, you should be able to retain the company shares even if you leave the company.
Workers who believe in their company's long-term potential may want to hold on to those shares, even many years after working for the company. It's not a good idea to concentrate too much of your wealth in one company's stock. But there's no reason it can't be a part of your long-term portfolio.
Be aware: Some employers don't issue regular shares of common stock as RSUs. The company may restrict dividends or voting rights, so read your RSU agreement carefully.
Example of Restricted Stock Units
To help you understand how RSUs work, here's an example. Let's say your employer offers you a grant of 1,000 RSUs. You earn 500 shares after one year and the second lot of 500 shares after two years.
After your first year, the stock price is $20 per share and you are awarded 500 shares worth $10,000. After another year, the stock price is $25 per share and you are awarded 500 more shares. If you kept the original 500, you now own a total of 1,000 shares worth $25,000.
How Do Stock Options Work?
An employee stock option plan gives employees the right (but not the obligation) to buy company stock at a specific price on a particular date. With a stock option plan, employees don't receive full shares of stock. Instead, they get the option to buy stock in the future, which may or may not ultimately prove to be beneficial.
Employee stock options work just like options in the public markets.
All stock options, including employee stock options, use the term “strike price” to denote the share price on the option's maturity date. If the market price per share is higher than the strike price, the options should be exercised. If the stock price is lower than the strike price, the options expire without any value.
Some employee stock options give you a period of time to exercise once you've reached a specific vesting date. In that case, you can wait for the stock price to increase if your options are not initially in the money.
Find out more: What Is Options Trading?
Example of Stock Options
Let's say your employer offers you stock options for 1,000 shares of company stock, to be vested December 31 next year. When the options were issued, the share price was $50 per share and the options had a strike price of $45 per share.
On December 31, the stock price is $55 per share, making the options in the money. You exercise the options and sell the shares right away. This nets you a gain of $10 per share. In total, you made $10,000 from the options (before brokerage fees and taxes).
Things didn't work out so well for your co-worker, however. They joined the company a few months after you and were issued options with a strike price of $60 per share and the same maturity date. Because the stock price of $55 per share is less than the strike price, your coworker's options ended up worthless.
Tax Treatment of RSUs and Options
Whether your incentive plan includes restricted stock units or incentive stock options, remember that any profits are a taxable gain. When your RSUs vest and you receive the shares of stock, you pay tax on the price of the shares at your regular income tax rate.
When you exercise your stock options, you pay for the stock (though at a hopefully reduced stock price) and have no tax obligation. But when you sell your stock, you pay tax at either your regular income tax rate or the more favorable capital gains rate, depending on how long you held the stock.
Capital gains taxes are treated differently from tax on ordinary income. If you have questions about how your equity compensation plan affects your income tax return, consider working with a trusted tax advisor or professional.
Advantages and Disadvantages of Stock Options vs. RSUs
The pros and cons of RSUs vs. stock options are different for the employee and employer.
For the employer, RSUs are essentially a guaranteed cost. RSUs give employees a share of the company directly. This of course makes the employee more loyal. However, the company knows it will have to pay for those shares at some point as long as the employee sticks around and meets the RSU vesting criteria.
Options give the company a bit more wiggle room. In addition to employee performance, the value of options relies on the stock price. If the stock price goes down and employee options expire out of the money, the company saves the cost. If the stock price goes up, the company rewards employees for a job well done and covers the difference between the option price and the current market price. With options, the company is not paying for a full share of stock for the employee.
Why Would an Investor Want an RSU Instead of a Stock Option?
RSUs are more valuable than stock options. With an RSU, the employee is rewarded with a full share of stock that they don't have to pay for. As you can see in the examples above, the numbers work heavily in favor of employees who receive shares instead of options.
“RSUs are more valuable than stock options.”
Stock options are less ideal for two reasons. First, if the stock price goes down, the options may be worth nothing. Second, if the price goes up, the employee has to pay for the shares at the strike price if they want to keep the shares. Alternatively, the employee can exercise the option and sell instantly to capture the profit, with no further upside potential.
It's better to get a share of stock than the option to buy a share of stock. That makes RSUs preferable for employees. However, the opposite is true for employers. But whether RSUs or options, everyone wins. The employee has incentive to help the company grow, and the company gains a productive employee.
At the end of the day, most employees outside of the executive ranks are lucky to get a slice of company ownership through RSUs or stock options. While RSUs are a bit better for employees, both are great additions to compensation plans.