The Difference Between an RSU and a Stock Option
Employers often offer two types of incentives to make their employees stay with the company for a longer period: stock options and RSUs.
What is a Stock Option?
A stock option (aka employee share option) represents an employee’s right to purchase in the future a pre-determined number of common shares at an agreed price. Availing the stock option doesn’t mean the employee owns the actual shares. Employees also won’t get voting rights, dividends, and associated advantages related to the stock that other shareholders enjoy.
Stock options are designed to encourage employees to help the company become better within a specific timeframe. The goal is to increase the value of the company’s shares by improving the business. The growth of the company benefits both the business and its employees as they can both reap the rewards of expanding corporate value.
For instance, an employee is offered 5,000 shares in stock options at $10 per share. The employer offers an agreement that the rights to the stock option can be exercised only after 3 years in the company. To get the most out of the stock option, the employee must do their best to contribute to the company’s growth within the said period.
After 3 years, employees can exercise their right and decide can either keep or sell the stock option, depending on the current market valuation of the company’s shares. If the current stock price is selling at $15, the employee would have profited $5 per share since they’ve bought it at a discounted price of $10 per share. However, if the current stock price is selling at $8, the employee would have lost $2 per share.
What is an RSU?
A restricted stock unit (RSU) is a type of incentive that a company gives to employees at a set date in the future. Companies often award this to outstanding employees that they want to keep for a long time.
An RSU can be given in any form, including shares or cash. But before an RSU can be awarded, both parties must go through a process called vesting.
Vesting is the process of awarding rights to an asset in the future after meeting specific conditions. In the corporate setting, the condition can include reaching a company milestone, being tenured for several years, or achieving a performance target.
Which is Better?
Compared to stock options that are awarded in full, RSUs are given in tranches. For example, an employer can give 5,000 shares to be given in tranches of 1,000 for the next 5 years to encourage an employee to stay with the company for the said period. In case the employee leaves on year 3, they’ll only get 3,000 units of the promised shares.
Stock options are always converted to shares. On the other hand, RSUs offer better flexibility as they can be awarded either as stocks or cash.
Stock options are more prone to fluctuations in stock price. There’s the possibility for the price to go lower than the agreed strike price, leaving employees with an unprofitable asset even after they worked so hard for the company. On the other hand, RSUs are more resilient to price fluctuations because they’ll be awarded at the current market price.
The biggest difference between an RSU and a stock option is tax treatment. Capital gains from stock options are counted as income when the rights over them are exercised. On the other hand, RSUs are taxed the moment they’re vested.
RSUs and stock options both serve the purpose of maintaining employee engagement and interest in working with the company. The answer depends on the goals of the company, their growth projection, and their capacity to pay the incentives.