In the ever-evolving landscape of employee compensation, the choices can often resemble a complex puzzle. Among the myriad of options available, two popular vehicles for rewarding employees stand out: stock options and restricted stock units. These compensation vehicles have become a central focus for both employees and employers seeking to align their interests and incentivize performance.
The decision to choose between stock options and restricted stock units is not one to be taken lightly. The way these forms of equity compensation work are considerably different, so it’s important to fully understand the impacts to cash flow, taxes, and your bottom line.
If you’ve landed a job offering both the option to receive long-term incentive pay in the form of stock options and/or restricted stock options, which should you pick? Or potentially you’re familiar with one form of equity compensation from a former job and want to compare against what you’re latest employer is offering. Let’s explore both so you can better understand how the uniqueness of each form of equity compensation may work to your benefit.
Overview of Employee Stock Options (ESOs)
An employee stock option (ESO) is a form of equity compensation granted to employees as an incentive to remain with the company long-term and help the company meet its performance goals. It’s important to distinguish that with ESOs, shares of company stock are not granted directly to the employee. Instead, as the name indicates, employees are given options allowing them to purchase company stock at a predetermined price for a period of time. The benefit is that if company stock performs well, employees may be able to purchase shares for a discounted price (the option’s exercise price).
ESOs are common incentives for employees or executives of start-up companies who are tight on initial capital but anticipate future growth. Let’s look at the need-to-know terms, comparisons, and considerations of ESOs.
ESOs come in two flavors, non-qualified stock options (NSOs) and incentive stock options (ISOs). The main difference between the two being tax-treatment.
For NSOs, once exercised, you are taxed on the “spread,” the difference between the market price and the grant price. It is treated as ordinary income. Once sold, you pay capital gains tax on any subsequent gain.
The spread on ISOs isn’t subject to tax when exercised. They are taxed at sale, and may fall under ordinary income or capital gains depending on how long the shares were held. ISOs are also captured under the alternative minimum tax (AMT) calculation.
Terms to Know
If an employer offers you ESOs, there are some key terms to know.
Vesting period: Employees must wait a certain amount of time, known as the vesting period before they can exercise their options. This period is set to ensure employees remain with the company long-term. Vesting periods will vary by company, but they could be six months, one year, two years, five years, etc.
Expiration date: Stock options come with expiration dates, and you cannot exercise your options once that date has passed. The expiration date is typically 10 years from when the options are granted. Your options may also expire if you leave the company for any reason, usually within 90 days of your last day of employment.
Strike, grant, or exercise price: This is the price at which your company will allow you to purchase shares of stock.
Spread: the difference between the market price and the grant price.
In the money: If your strike price is less than the current market price, you can purchase company stock for less than market value. This means your options are “in the money.” If your current market value is $100 a share and your strike price is $80 a share, you can purchase company stock for a $20 discount. That’s an example of options being “in the money.”
What Does It Mean If Your Stock Options Are “Underwater”?
If you hear that your options are “underwater,” it’s essentially the opposite of your options being “in the money.”
In this case, the current market price of company shares is lower than your exercise or strike price. Looking at our example earlier, if shares are currently $100 a piece and your strike price is $120 a piece, your options are “underwater.”
When options are “underwater,” employees are much less motivated to exercise them. They may choose to wait and hope share prices rebound, for example. Some companies may reprice their strike price based on these changes to the market value, though this is never guaranteed.
Restricted Stock Units (RSUs)
RSUs are another form of equity compensation employers can offer to incentivize employee performance and retention. The critical difference is that ESOs provide the option to purchase stock, while RSUs are a set number of actual shares in company stock promised to the employee. Do you have RSUs? Read how employees can take advantage of RSUs.
Employees must wait until the vesting period has ended before they can do anything with the stock, such as sell it. RSUs do not have a strike or exercise price because employees do not purchase shares.
Along with the vesting period, some companies will allow employees to sell their shares once the company reaches a particular milestone (such as revenue goal, acquisition, etc.).
Once the employee receives their set shares of company stock, the fair market value of those shares will count toward the employee’s ordinary income for the year they’re vested. If the employee chooses to hold on to the stock and sell it later, they will have to report the difference between the sale price and the price of the shares on the day they vested as either a capital loss or gain.
The Differences Between ESOs and RSUs
When comparing ESOs to RSUs, there are a few key differences to consider. While RSUs are essentially free shares of stock granted by a company, they lack flexibility in timing and ownership.
ESOs, on the other hand, offer more flexibility because employees can choose when to exercise their options. In addition, they can achieve higher returns if the stock price increases significantly above the exercise price. However, there’s always the risk that employee options will become “underwater,” as we discussed earlier.
If your company does offer the option between ESOs and RSUs (or if you’re comparing two job offers with varying equity comp packages), work closely with a financial advisor and tax professional to weigh your options. Remember that equity compensation relies on company performance and market outlook. A start-up may offer an impressive equity compensation package, but if it can’t carve a niche in the market, those stock options may eventually become worthless. Because the tax treatment varies between these two options, it’s essential to discuss the potential tax liability of your equity compensation package with a tax professional before the vesting period ends.
Understanding Your Equity Compensation Options
When managed effectively and strategically, equity compensation can help employees grow their net worth significantly and achieve their financial goals. And if you have a choice between ESOs and RSUs, there are plenty of factors to consider, such as creating cash to cover the cost of exercising options, utilizing 10b5-1s to avoid unintentional insider trading, navigating black-out periods, aforementioned tax nuances between incentive and non-incentive stock options, and much more. You also want to be sure not to end up with too much employer stock making up your net worth. Please contact our team; we can help you review your options for your greater financial picture.