Stock Options and RSUs – What’s the difference?
Organizations often offer various incentives to employees to encourage them to increase their output or stay longer to serve the company. In addition to salary increases, companies may offer stock options or restricted stock units (RSU) to deserving employees.
But what’s the difference between the two? Which one is better?
Here’s a short summary of the concept behind each benefit for those who can’t remember the difference.
What are employee share options?
Also called stock options, employee share options represent the right of an employee to purchase a pre-determined number of common company shares in the future for an agreed price. Employees who avail stock options don’t own the actual stocks yet. They also don’t receive any voting rights, dividends, and other advantages other shareholders do.
For example, an employee is offered 1,000 shares in stock options priced at $5 per share. According to the agreement, the employee can exercise their rights 5 years after joining the company. To maximize the possible gains, the employee is encouraged to do all their best to grow the company and increase the value of its stock price. After 5 years, the employee can now do what they want with the option. If the current stock price rose to $10 per share and they decide to sell, they’ll have a gross profit of $5,000.
Typically, stock options are priced at a discount from the current market value to make it more enticing as a form of performance incentive. Stock options are valid only up to 10 years upon the date of issuance.
What are RSUs?
An RSU is a form of incentive a company commits to giving to employees at a later date. This is usually offered to exceptional employees a company wants to keep for a long time.
An RSU can be given in the form of shares or cash but before anything is awarded, both parties have to go through vesting. Vesting is the process of awarding a right, an asset, or a benefit to someone in the future after satisfying certain conditions. Requirements can be based on performance, tenure, or company milestone. Also, compared to stock options which can be exercised to the employee’s preference, RSUs are given in tranches.
For example, an employee is offered 1,000 RSUs to be awarded for the next 5 years in tranches of 200. If during this period the employee decides to leave just after 3 years, they’ll only get 600 shares in the process.
So which is better?
Although they serve similar purposes, there are many differences between the two forms of employee incentive.
For one, there’s the choice of payment. Stock options are always converted to common shares while an RSU can be awarded either as cash or as stocks.
Stock options grant employees both voting and dividend rights. On the other hand, RSUs don’t come with voting rights or dividends.
With stock options, employees have to buy the shares at the strike price and wait for the stock price to go up to make the trade profitable. This can be risky because there’s always the possibility of the stock having a lower market average than the strike price you’re offered. On the other hand, RSUs aren’t affected by these fluctuations because they’ll have value regardless of the stock’s current price.
Perhaps the biggest difference between the two is tax treatment. Gains from stock options are taxed as income the moment you exercise your right on them as opposed to RSUs which are taxed as soon as they’re vested.
RSUs aren’t better than stock options. Each has its own benefits and drawbacks that can work for or against your career plan and risk appetite. RSUs are less volatile and work best if you plan to stay in the company until you retire. Stock options, on the other hand, are riskier but may offer larger profits if sold at the right price.
Now that you’re more informed of the differences between a stock option and an RSU, you’ll be able to make better decisions in which employer incentive to invest in.