These differences include:
There is a lot to know about restricted stock units (RSUs). Employees receive stock-based compensation in the form of RSUs and stock options as a way for companies to align the interests of their employees and shareholders, as well as provide incentives for performance and retain talented individuals.
RSUs are typically granted to employees as part of their overall compensation package. When an employee is awarded RSUs, they don’t receive actual shares immediately. Instead, they receive a promise — or unit — that represents the right to receive shares of company stock in the future.
Stock options are a way for employees to benefit from the company's stock price appreciation. By tying compensation to the company's performance in the stock market, employees are incentivized to contribute to its growth and success. These options are often granted as part of an initial employment package, annual grants, or performance-based rewards.
Unlike RSUs that ultimately convert into a set number of shares, stock options give employees the opportunity to buy a specific number of shares at a predetermined price — known as the strike or exercise price. Typically, the exercise price is set at the fair market value of the company's stock on the date of the grant. Employees can exercise their options once they become vested, allowing them to purchase company shares at the predetermined price.
Stock options allow employees to purchase a specific number of shares at a predetermined strike price. The options do not represent actual ownership of the shares until exercised. There are generally two types of options granted: non-qualified and incentive stock options. There are notable differences between both options in terms of eligibility, expiration period, maximum value, and others. For example:
Non-qualified stock options (NSOs) are offered to employees and contractors and have no set term or maximum value.
Incentive stock options (ISOs) are only offered to employees, have a maximum term of ten years, and a maximum grant value of $100,000 in any calendar year.
The vesting schedule for stock options is usually time-based or performance-based.
You may still be wondering: so what’s an RSU? An RSU explained in the simplest of terms is a representation of the right to receive a set number of shares in the future. When RSUs are granted, the company promises to issue the shares of stock to the employee at a future date. When the vesting period ends, the employee receives the specified number of shares.
In terms of vesting schedules, most RSUs follow a time-based or graded vesting schedule. Similar to stock options, a common structure is a three- to four-year vesting period with a one-year cliff.
RSUs and stock options affect employee compensation differently. For RSUs, when granted, they have a specific value assigned to them. This value is typically based on the market price of the company's stock at the time of grant. The grant value represents an additional portion of compensation that the employee will receive in the future. Once the RSUs vest, if the company pays a dividend, those payouts will be paid to the employee as well.
Stock options are typically granted with a specific exercise or grant price, which is the price at which the employee can buy the company's stock in the future. The grant price is usually based on the market price of the stock at the time of the option grant. If the company's stock price rises above the grant price, then the employee can purchase the stock at a lower price, benefitting from the price appreciation and increasing the employee's overall compensation.
However, if dividends are paid by the company between the period of grant and exercise, the employee is not eligible to receive them. Additionally, stock options have an expiration period: typically several years after the grant date. If the options aren’t exercised before the expiration date, they expire worthless.
The short answer is it depends. Since stock options are more volatile in nature, they can achieve significant gains but also precipitous declines if employees are willing to take on the risk of not selling immediately after vesting. RSUs, on the other hand, tend to offer more predictable performance, with a steady stream of equity compensation that might never reach the highs of a company stock option. Here’s a comparison of the biggest differences between RSUs and stock options:
Requires cash to acquire?
Only when exercised
When vested or earlier if equivalent rights exist
Market and expiration
When RSUs vest, they are considered taxable compensation, and the employee is subject to income tax on the value of the vested shares. Every company may withhold a portion of the shares to cover the tax liability. For example, an employee may be due ten shares at a particular vesting date but only receive eight shares as the remaining two are held back to pay taxes.
For NSOs, the employee is taxed when the options are exercised, and the resulting gain is subject to income tax. For ISOs, the employee may qualify for favorable tax treatment, but there are specific holding periods and other requirements to meet.
In both cases, when the shares held are sold, this triggers capital gains tax, whose rate will depend on the length of the holding period.
The value of RSUs is directly tied to the company's stock price. When RSUs vest, the employee receives the value of the vested shares based on the stock price at that time. It’s important to note that RSUs may be granted as actual units or based on some dollar amount. If the latter, when the RSUs are granted, the stock price on the day of the grant determines the number of units. As stock prices fluctuate during the life of the vesting periods, the value of those RSUs will fluctuate too.
Option valuation is a broad and complicated topic, but the basics are as follows. Prior to expiration, the value of an option is determined by six factors:
Time to expiration
Dividend, if present
At expiration, the value is determined by whether the stock price is above the exercise price. If it is, the difference is the value of the option. If not, it’s worthless.
RSUs typically have a predetermined vesting period during which the employee cannot sell or transfer the underlying shares. Once the RSUs vest, the shares are usually delivered to the employee, and they can choose to sell them immediately or hold onto them. Importantly, they can collect a dividend if the company pays one. In contrast, stock options require the employee to exercise the options by purchasing the underlying shares at the exercise price. Until the options are exercised, employees do not own the shares and cannot sell them or the options. The timing of liquidity for stock options depends on when the employee chooses to exercise the options and/or sell the acquired shares.
When exercising stock options, employees need to pay the exercise price to acquire the shares. This requires the availability of cash or the ability to finance the exercise. Sometimes, companies provide that financing. In contrast, RSUs do not typically require any cash payment from the employee. The shares are granted without an upfront cost.
In both cases, the employee is exposed to the market risk inherent in the stock. And if you’re wondering what an acquisition means for employees holding stock options, know that it can have profound implications.
There are many nuances to restricted stock units and stock options. If you need assistance or specific recommendations on the subject, it’s best to consult a tax professional or financial advisor to help you understand their current needs and tax implications to plan accordingly.
Amanda brings 30 years of experience in banking and finance.