Understand the pros and cons of these equity types, their tax implications, and how to handle them.
Your company’s IPO announcement can get the wheels in your head turning about what exact equity you have and how you think about these assets.
I’ve noticed a lot of my clients refer to equity compensation or employee equity as “stock options,” but that’s not entirely accurate. Stock options are just one type of equity compensation. There are actually two main types of employee equity you may deal with: restricted stock units (RSUs) and stock options. You can have both or one of these equity types. Either way, you’ll want to get familiar with these terms.
Grasping these technical terms is key to understanding your grant agreement, which tells you exactly what you have leading up to your IPO.
Every time I work with a new client, I determine the things they have a good handle on, versus things they have questions about. They often ask what the difference between RSUs and stock options is. In this post, we’ll not only discuss the differences between these types of employee equity, we’ll also dive into how each of them work, their tax implications, and which one’s better.
RSUs vs stock options: The basics
Put simply, stock options are the right to purchase a quantity of shares at a fixed price.
Here are a couple terms we use when discussing stock options:
- Exercise: Exercising your options means purchasing the shares your company has offered you. A stock option is simply the option to purchase shares — it’s a right you’ve been granted. When you purchase your shares, that’s when you’re exercising that right.
- Exercise price: This is the fixed price at which you can purchase shares. An example would be the option to purchase 10,000 shares at a price of $2.50 per share.
Some people also refer to exercise and exercise price as strike and strike price. You may hear someone say, “I’m going to strike my options,” which is another way of saying, “I’m going to purchase the shares.” But I’ll stick to exercise and exercise price to keep things simple.
For the entire time you possess the right to purchase shares, your exercise price is fixed, regardless of how much the company’s stock price may fluctuate. This can be an especially powerful feature if your company’s stock price significantly balloons after your exercise price is set. It could make for a life-changing payday down the road.
Another important concept to understand is vesting, which in terms of stock options is time based. When you receive your grant agreement, you’ll see a schedule by which your stock options will vest. This is what we call a vesting schedule. It could be monthly, quarterly, or annual. Once your options vest, you can exercise that portion of options from your stock option grant. For instance, if you’re halfway through your vesting schedule, you have the right to exercise 50% of the total options you’ve been granted. If your options are fully vested, that means you can exercise 100% of the options you’ve been granted.
Arguably one of the most important distinctions between stock options and RSUs is their tax implications. With stock options, taxes don’t come into play until you exercise. Depending on the type of stock option you have and the type of tax, the taxes may be triggered at exercise, sell, or both. Simply being granted options or having those options vest doesn’t trigger a taxable event, only taking action does.
There are two types of stock options:
- Incentive stock options (ISOs)
- Non-qualified stock options (NSOs)
With incentive stock options, there’s no regular income tax at exercise, but exercising may trigger alternative minimum tax (AMT). Selling triggers a taxable event that’s determined by the taxes you did and didn’t pay at exercise, and whether your sale equates to a gain or a loss.
In cases where you exercise an ISO, which triggers AMT, and the stock price continues to rise, you eventually sell at a higher price than the stock price when you exercised. This could result in you paying taxes at both exercise and the sale (AMT at exercise and potentially additional taxes on any gain from exercise to sale).
Exercising non-qualified stock options is a taxable event for purposes of the regular income tax, assuming there’s a positive difference between what the stock is worth and your exercise price. alternative minimum tax doesn’t apply to NSOs. You may also pay additional taxes on a profitable sale, depending on the difference between the stock price at the time of exercise and the stock price at which you eventually sell.
There are two rules that distinguish ISOs from NSOs: the $100,000 rule and the 90-day rule. You’ll want to have a good understanding of these key rules when considering ISOs.
The $100,000 rule states that you can’t have more than $100,000 of ISOs (based on the value at grant) vesting in any one calendar year. That’s why larger stock option grants typically involve both ISOs and NSOs. Or in the case of executives, where stock option grants are especially big, they can come in the form of NSOs only.
The other rule that applies to incentive stock options is the 90-day rule. In order for a stock option to qualify as an ISO, you have to have been an employee within 90 days of exercise, though you may deal with extended post-termination exercise periods. Even if 100% of your stock option grant was in ISOs at the time of grant, once you’re 90 days past leaving the company (assuming the option grant hasn’t expired), it becomes a non-qualified stock option.
Restricted stock units
RSUs are a grant of a fixed number of shares which vest over a specified period of time. Like with stock options, the vesting is time based. However, the stock option concepts of exercise and exercise price don’t apply to RSUs.
What differentiates RSUs from stock options is their time-based vesting may or may not have an event trigger. When there is an event trigger, the RSUs will vest over time but they won’t actually be released or settled until the second event-based trigger occurs (e.g. an IPO).
Get familiar with the RSU term “release or settlement.” With RSUs, you get a grant of a certain number of shares vesting over time. On a given vest date, the specified number of shares for that date effectively become yours but you don’t actually receive the shares until the RSUs are released or settled, which is the point at which the shares are transferred into your account.
An restricted stock unit example may look like a grant of 10,000 shares vesting quarterly over four years. In this case, there are 16 vest dates. In the first quarter of vesting, 625 shares will vest and release. There’s no event-based restriction, meaning the time-based vesting schedule and the release are one in the same. On that date, 625 shares will vest and release and become yours.
With RSUs, it’s the release or the settlement of the shares that triggers the taxes. The value of the shares that are released or settled are fully taxed as ordinary income on the day those shares are released or settled.
Partial-value vs full-value awards
Understanding the difference between partial-value and full-value awards will help you grasp the distinction between RSUs and stock options.
For starters, an award is a grant of equity compensation, which is the form in which you receive both RSUs and stock options.
Stock options are partial-value awards meaning the option’s worth to you is determined by the fair market value or stock price minus the exercise price. So even in the case of cashless exercise, the exercise price is still a real value you must give up to exercise the option and purchase the shares,
On the other hand, RSUs are a full-value award. There’s no price that you have to pay or action you must take in the form of exercising. The RSUs vest, the shares are released, and you get all of it — the full value of those shares and the stock price, whatever it may be at the time.
Which is better? RSUs vs stock options
Stock options certainly have their advantages, one of which is that generally nothing happens until you exercise. With stock options, you get to choose when you have to lay out the cash to exercise and when the taxes get triggered. Stock options give you a lot more choices to potentially make than RSUs do, ultimately giving you more ways to try to minimize taxes. Being a double-edged sword, having more choices can serve as a disadvantage, since you have many more considerations and decisions to make.
Having worked with professionals who’ve gone through IPOs with stock options, I’ve noticed an advantage many of them experience: As their employers transition from startup to IPO, they also tend to change the types of equity they grant. Early on, the companies often grant stock options, and at some point in time, they switch to restricted stock units. Employees who go through IPOs with stock options have the advantage of more options than someone who only has RSUs. The earlier you join a company, the more likely you are to get stock options. Another advantage of being an early employee is that the size of your grants — in terms of options or RSUs — tend to be much larger. And if you were early enough to have stock options and stuck around, you may now have RSUs too. This would mean you have even more things to consider and ways to leverage the differences between stock options and RSUs.
Though stock options have many advantages, RSUs are good too. First of which is that RSUs offer a full-value award. Meaning even If the stock performs poorly, you’ll still receive some value. Whereas with stock options, bad-performing stock can deem your equity worthless. You can also be in a situation where you exercise, and with ISOs, trigger the AMT, on a stock price that was much higher at exercise than it is now. RSUs are simpler than stock options and there’s less to think about and fewer choices to make when handling them.
Though advantageous in some ways, RSUs have downsides too. With less choice comes less control, especially during, say, an IPO with double-trigger RSUs that had a time-based vesting schedule and an event based trigger for their release. Your company may have chosen to release the RSUs at the IPO but you’re still dealing with a lockup and are unable to sell for at least six months, during which the stock price could decline and lead to an unfavorable situation.
With both RSUs and stock options, stock price and stock performance from the IPO to the first trading window and beyond ultimately determines your outcome. There are differences between the two but the price will ultimately determine how much cash you have on hand once everything is said and done. The key is knowing the difference between the two – and if you have both, knowing the relationship between the two to best determine how to take advantage of your unique situation.
Side note: if you’re in the unique position of planning for an IPO before exercising your options, I have a blog post about that. It’s a good position to be in because you haven’t made any mistakes yet and can start with a clean slate.
RSUs vs stock options: The specifics
Getting more granular, let’s discuss specifics around stock options and RSUs, starting with the former.
There are two decisions at play with stock options:
- Exercise by using your right to purchase shares at a fixed price
- Sell your shares
And like we discussed earlier, there are two main types of stock options that may be at play. Here’s how to navigate each one:
Non-qualified stock options: The recommended course of action for NSOs is almost always to exercise and sell. After your IPO, identify a target price (a price at which you’re happy to start selling) and then exercise and sell the NSOs in a single event. In other words, you’ll trigger ordinary income tax by exercising, then almost immediately sell your shares from the NSOs to cover your high tax bill. Keep in mind there’s very little advantage to exercising and holding NSOs.
Incentive stock options: With ISOs, you can consider either exercising and holding or exercising and selling. We’ve even written a case study on the difference between these two avenues. The main lesson? Just because you can exercise and hold to eventually sell and get taxes at long-term capital gains rates and minimize your taxes, doesn’t mean you should.
Remember how taxes are always the last priority on the three factors list, while price is paramount. By exercising and holding, you expose yourself to a lot of risk — the price can drop quickly and during a period when you’re unable to sell, potentially eliminating any tax advantage you’re trying to create. Simply having ISOs isn’t reason enough to exercise and hold. But since this strategy is more of a possibility with ISOs, you could be looking at a series of choices that will play out over a number of years. With that in mind, we’ve written about the year-by-year approach we’d take with ISOs, along with a month-by-month plan within each year.
Restricted stock units
Getting into the specifics of RSUs, it’s important to remember that taxes will occur regardless of your actions. RSUs have a time-based vesting schedule that may involve an event-based trigger but whenever they release and settle as shares, you’ll pay taxes on that value.
Develop an understanding of how income tax withholding works on restricted stock units. In some cases you may be given a choice ahead of or after the IPO around the withholding you want on those RSUs. If given the choice, pay close attention and make an informed decision. With RSUs, there’s really only one decision you need to make: when to sell after the RSU has released and the shares have settled.
We generally treat RSUs similarly to NSOs, where the recommendation is to sell as soon as possible once the shares are released. However, an IPO is the one time we may deviate from that standard recommendation. That’s because you may have a large number of RSUs that settle on the IPO date, but then it may be six months before you can actually sell those shares. The stock price may fluctuate during that lockup period. You’ll want to consider that price information when determining whether to sell during your first trading window or continue to hold onto the RSUs you’ve been granted. Beyond your IPO, consider getting into a routine with your RSUs, where you may have quarterly vesting matching up with quarterly trading windows. Think about what your ongoing plan for your RSUs is, beyond the IPO.
Time to start planning
We covered a lot of ground today. Stock options and restricted stock units each have advantages and disadvantages. The smartest thing you can do is understand the specifics of how each one works and apply that knowledge to your unique situation, especially if you have both. Knowing how to combine the advantages of stock options and RSUs in unique ways is key here.
Helping professionals in your same shoes successfully navigate their IPOs is something we’re especially good at. Book a call today to talk to myself or another expert on our team about planning for your IPO.