RSU vs. Stock Options: What These Employee Incentives Mean

The normal way to obtain shares in a company is to make a financial investment. Since the 1990s, though, the concept of “sweat equity”—the contribution valued employees make due to special effort, education, leadership, or intellectual property—has become increasingly formalized.

In a nutshell, companies have two similar but quite different alternatives they may choose to include in their compensation packages: RSUs vs. stock options. Which is better?

Both amount to a promise to reward an employee based on the company’s share price, but there are important differences between them.

Stock Options vs. RSUs: Where They Come From

There are many ways for startups—new companies with an innovative business model and high growth potential—to reward their employees. Inflating job titles compared to the actual responsibilities involved and the ever-popular foosball table in the break room, however, aren’t considered as impressive as they used to be.

Employees know that the time value of money has a special significance for companies poised for growth. Such an enterprise may expect to be drowning in cash and equity in a few years but have limited cash flow right now. Yet, its success depends on hiring skilled people who expect to be compensated for taking a risk on a new venture instead of joining an established company.

If this is the case, companies can still reward star employees commensurately with the growth they will help create…but only once it has actually been created.

What Are RSUs & How Do They Work?

Despite the rather technical name, they’re actually quite straightforward compared to employer-offered stock options.
Whether we’re talking about RSUs or options, the foundation of such an agreement is that employees are compensated later for work done now.

In the case of restricted stock units, this means that the company promises to provide them with a number of free shares or their cash equivalent.

An Example of RSU

How do RSUs work in practice? Let’s say that Jonathan Jellybean joins a company that has recently undergone an IPO. He and his new employer negotiate a contract for a lower monthly salary, offset by 1,000 shares in RSU stock next year.

The benefit to the company is that they don’t have to give Jonathan cash right now, which they’d prefer to spend on immediate essentials like rent and software licences. Jonathan, meanwhile, is pleased with his potential upside if the share price rises.

Once the RSU vesting period runs out, Jonathan receives those 1,000 shares, free and clear, without having to pay for them. He can sell them immediately, generating a nice windfall. Even if the company goes out of business, he hasn’t made a loss: he didn’t risk any of his own money.

What Are Stock Options & How Do They Work?

Normally, stock options are bought and sold by investors, not granted by employers as part of a compensation package, but the principle remains much the same.

Basically, the owner of such an option obtains the right to buy shares in some company at a future date for a price agreed on beforehand. If the value of the stock exceeds expectations, the investor might make a killing. If the shares fall below the designated value—called the “strike price”—the owner is not out of pocket: they can choose whether or not to exercise the option.

Naturally, this power to use or ignore the option doesn’t come for free. Investors who buy options pay a fee for the privilege.

Company stock options, by contrast, are a kind of thank-you to employees and don’t carry this cost.

Example of a Stock Option

Jonathan’s childhood friend Kelly Knickerdoodle goes to work at a company that prefers to offer stock options vs. RSUs. At the time she joins, its shares are trading at $12.

Her employment contract specifies the right to buy 100 shares at a strike price of $15, after two years of employment.

When this vesting period—intended to encourage employee loyalty and motivation—expires, the share price will have climbed to $20 on the open market.

She promptly buys a hundred shares from the company for $1,500 and sells them the next day for a $500 profit.

RSUs vs. Stock Options: Which Is Better?

Something we skipped over in the tale of Jonathan Jellybean is that RSUs are frequently only valid once certain defined conditions have been met. These often include a private company going public or individual performance milestones being reached by Jonathan himself.

This restriction makes RSUs somewhat less attractive to employees.

On the other hand, if Kelly’s employer’s value per share dips below the strike price, her stock options become worthless.

In addition, she can’t exercise them if she doesn’t have or borrow $1,500 to purchase the shares. Jonathan simply receives the shares or their cash value – the sum may be less than what he hoped for, but won’t be zero.

Key Differences Between RSU vs. Stock Options

In most other ways, however, stock options and RSUs are very similar. Both require an employee to remain with the company until these rewards vest.

Both represent a kind of bonus if the company thrives, linking the self-interest of employees, management, and stockholders.

Also, both options and RSUs have similar tax implications – though the practical differences may be significant in a particular situation.

Options vs. RSU Taxes

Should the vesting period of a stock option or RSU be on your horizon, you should understand that it may be taxed as capital gains or ordinary income.

The capital gains rate is generally more favorable but may not be available to you (or even be charged in addition to income tax).

In general, RSU taxes are based on your total income in the year they are exercised, but they are also taxed as capital gains if you hold them for a year or more.

The situation with stock options depends on their specific legal format, but you can expect to pay income tax on them unless the Alternative Minimum Tax comes into play.

However, it should be possible to spread your income tax liability over several years, unlike with RSUs.

As always, placing the proceeds in a 401(k) or IRA should reduce your tax burden, as will asking a professional financial planner for their opinion.

The Bottom Line: Which Is Better for You?

Hopefully, the above summary made the differences between RSUs vs. stock options clear. Understanding their distinctions isn’t a substitute for actually reading your employment contract, though.

You may find that there are certain wrinkles you have to take into account. Restricted stock awards, for instance, may be paid in either cash or shares at the company’s discretion. If an employee is given stock, they may be wise to hold onto it for a while or choose to sell it immediately.

When it comes to personal finance decisions, the best advice is always to do your research and consult an advisor if necessary. While either RSUs or options can benefit you, making the most of either requires a bit of planning.

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