Restricted Stock Units (RSUs) vs. Stock Options: Which Is Better?
Times used to be simpler, at least as far as startup equity is concerned. It used to be that stock options were the primary form of equity-based compensation a startup could offer to attract talented employees. But the growing popularity of restricted stock units (RSUs) as an alternative to stock options has muddied the equity waters a bit.
The question of equity-based compensation is no longer simply a matter of, “Do I offer it and how much?” Today’s startup founders also have to weigh the pros and cons of RSUs and stock options. The correct answer depends on a number of factors, and it may change as your company evolves from a young hatchling to a full-blown, venture-backed powerhouse.
In this article, we’ll take a look at the key differences between RSUs and stock options to help you figure out which equity type is right for you.
RSUs vs. stock options: At-a-glance comparison.
Overview
- What is a restricted stock unit (RSU)?
- What is a stock option?
- 3 key differences between RSUs and stock options
- RSUs vs. stock options: Which is better for a growing startup?
What is a restricted stock unit (RSU)?
The term restricted stock unit (RSU) refers to a type of stock-based compensation that grants the employee a certain number of shares of company stock. These shares are typically subject to a vesting period or schedule, meaning that certain milestones must be met before the employee is granted the RSU. In some cases, these milestones are simply time-based — if the employee stays at the company for X number of years, he or she receives X number of vested RSUs. In other cases, an RSU vesting plan may also include performance goals or incentives.
How much are RSUs worth?
RSUs have no actual value until they vest. This incentivizes employees to stay at the company for at least as long as it takes for any RSUs granted to them to vest.
When they do vest, RSUs are assigned a fair market value and considered as ordinary income for tax purposes. It’s not uncommon for the income taxes on vested RSUs to be paid for with a portion of the vested shares, which are withheld. The remainder are granted to the employee, who can sell or hold onto them.
What is a stock option?
A stock option is a type of compensation that allows — but does not obligate — the employee to purchase a number of shares of company stock at a fixed exercise price. This exercise price is also sometimes referred to as a “strike price.”
As we noted earlier, stock options are historically the most prevalent form of equity-based compensation, and with good reason. It used to be a fairly common practice that stock options were granted with exercise prices that were far below the fair market value of the common stock. This was a sweet deal for employees, who had the option to purchase common shares at a discounted stock price versus what, say, an outside investor might pay.
Stock options are still a pretty sweet deal for employees, but new regulations have changed how the exercise price for a granted stock option is set. Any private company issuing stock options now requires a 409A valuation, which sets the value of common shares. This value, in turn, informs the strike price of the options.
It’s important to note here that not all stock options are created equal — at least as far as taxation is concerned. There are two main types of stock options you should know about: incentive stock options (ISOs) and non-qualified stock options (NSOs).
What are Incentive Stock Options (ISOs)?
Incentive stock options are a type of stock option that can only be granted to employees. If they meet a certain set of criteria, they may qualify for preferential tax treatment under the United States Internal Revenue Code.
What type of preferential tax treatment? Employees who receive ISOs only pay taxes when they sell the stock. They are not on the hook for taxes when they exercise the options.
What are Non-Qualified Options (NSOs)?
Unlike ISOs, non-qualified stock options aren’t limited to employees—they can also be granted to contractors, directors, vendors, and other parties. And there’s no limit on the total value of NSOs that a company can grant in a given year.
With that said, NSOs do have some drawbacks. Namely, they are taxed at the ordinary income tax rate when they’re exercised. (Taxes apply to the difference between the exercise price and the fair market value of the common shares).
3 key differences between RSUs and stock options
Now that we’ve defined RSUs vs. stock options, let’s take a closer look at some of the key differences between the two types of equity.
1. Stock options have an exercise price—RSUs don’t
This may seem a bit obvious, but lack of an exercise price is an important factor that differentiates RSUs from stock options. Let’s break it down:
- With RSUs, the employee only has to fulfill the terms of the vesting schedule or plan in order for their RSUs to become common stock.
- With stock options, the employee is given the choice — the option, you might say — to either buy or sell the stock at a certain exercise price.
2. RSUs have value even if the company’s value doesn’t appreciate—stock options don’t
Some founders prefer the idea of stock options because they better incentivize employees to grow the value of the company they work for. Think about it: If you’re granted stock options at a certain valuation, you’ll likely work hard to ensure that the company’s valuation goes up, because this means that the value of your stock options will go up. If a company’s valuation stays the same or even depreciates, then the stock options don’t look so hot.
RSUs, on the other hand, retain some value regardless of how well the company performs in the coming months and years. This value may not end up being all that much if the value of the company depreciates, but it’s still some value. This is an important factor to consider when determining how many RSUs or stock options to include in an equity package. Generally speaking, an employee would receive fewer RSUs than stock options in an equity package of roughly equal value.
3. RSUs and stock options are taxed differently
Taxes aren’t just your employees’ problem. They can really make or break the value of an equity package, so it’s important to understand that RSUs and stock options aren’t the same in the eyes of the IRS. In fact, these two types of equity come with very different tax implications.
- With RSUs, employees don’t have to pay any taxes at the time of the grant. They must, however, pay taxes when the RSU is fully vested and liquid. RSUs are taxed at ordinary income tax rates, which can vary by state.
- With stock options, things are a bit more complicated. As a rule, options are only taxed after they’re exercised, but the specific taxes you’ll pay may differ based on the type of option. Gains or losses may be considered short- or long-term capital gains or losses, depending on whether the option is an ISO or an NSO and how long the stock is held after the option is exercised. One additional point to note is that ISOs may be subject to the alternative minimum tax (AMT), which is designed to make sure that certain taxpayers, generally with high income, pay at least a minimum tax, limiting their possible tax deductions and exclusions.
Taxes on equity — especially the AMT — can be complicated, and they are likely best navigated with help from a financial advisor or financial planning expert.
RSUs vs. stock options: Which is better for a growing startup?
So, which is better for a growing startup? Should you be filling your employees’ equity packages with RSUs or stock options? There aren’t always straightforward answers to these questions, but there are definitely some guidelines to keep in mind.
The case for stock options at early-stage startups
If your startup is still at an early stage but has raised some outside venture capital, it may be a good time to consider issuing stock options. At the earliest stages of your startup journey, you may consider granting shares of restricted stock (this is different from RSUs) to your employees. These shares are taxable, and as your company grows in value, the taxes your employees will have to pay on those shares will also continue to climb.
It’s at this moment — after some initial investment, but before your company reaches a much higher valuation — that issuing stock options may begin to make sense. Your employees won’t have to pay any taxes on the grant date, which is generally a good thing for them. They’ll also get an exercise price on their options that incentivizes them to grow the value of the company more in the coming years, so that their options continue to grow as the value of the shares grows.
The case for RSUs at later-stage startups
RSUs are a more popular form of equity compensation at public companies and later-stage startups that are pre-IPO. Why is this?
The exercise price of a stock option is based on the company’s current valuation. If your company has recently closed financing at a valuation that is way, way higher than what you’re likely to reach, then the value of any granted stock options goes down considerably for your employees.
This is where RSUs can step in and make a lot of sense. RSUs can be a good option for middle-stage startups that need to provide equity-based compensation in order to remain competitive in the market, but that can’t provide a great stock options package based on the current company valuation.
The bottom line
Equity compensation is an enticing employee benefit, no matter how you slice it. But Knowing which form of stock equity makes sense for your startup (or even understanding basic equity terms) can be a challenge for a new founder. The good news is that Pulley is here to help. Pulley has helped thousands of companies manage their equity in a way that’s fair to both employees and founders.
Schedule time with our cap table experts to get started today.