Stock options versus RSUs: Important considerations for startup employees

At startups, equity in the company is often a component in an employee’s compensation package. Two of the most common types of equity compensation are stock options and restricted stock units (RSUs). Both have potential advantages and disadvantages; therefore, understanding their differences is important to maximize potential compensation values, if both opportunities are presented. This article explores some things employees should know about these two equity types.

What are stock options and RSUs?

1. Employee stock options

An employee stock option is a type of equity compensation granted by companies to their employees. Rather than granting shares of stock directly, a company gives options which give you the right to purchase stock at a predetermined price, known as the "exercise price," or “strike price”, within a defined period of time. If the company’s share price surpasses the exercise price, employees can take advantage of purchasing the stock at a discount to its current value and possibly profit from the difference.

2. Restricted stock units (RSUs)

An RSU is an award of shares, usually given as a form of employee compensation. RSUs give employees interest in their employer's equity but have no tangible value until they are vested. The RSUs are assigned a fair market value (FMV) when they vest.

Both RSUs and stock options are commonly issued to employees pursuant to a vesting schedule after they achieve required performance milestones or upon remaining with their employer for a particular length of time. The most common vesting schedule is a four-year vesting period with a one-year cliff, meaning 25% of the equity vests after the first year, and the remaining 75% vests gradually over the next three years, often monthly or quarterly.

Key differences between stock options and RSUs

The following set stock options and RSUs apart from one another.

1. Right to purchase versus ownership

Ownership represents one of the key differences between RSUs and options.

Stock Options: With stock options, employees have the opportunity to purchase shares at a fixed price; however, they need to exercise the option in order to actually acquire the shares. If the company’s stock price is lower than the exercise price, the option is essentially valueless unless/until the value of the company appreciates.

RSUs: After RSUs vest, employees own the shares outright, with no purchase required on their part.

2. Taxation

Stock options and RSUs are subject to different tax treatment.

Stock options: Taxation on stock options depends on the type of options an employee has:

• Incentive stock options (ISOs): These are sometimes more tax favorable. If you hold the shares for a specific period after exercising the options, you might qualify for long-term capital gains treatment.
• Non-qualified stock options (NSOs): These are taxed at the time of exercise as ordinary income on the difference between the exercise price and the current market value.

RSUs: When RSUs vest, the value of the shares is taxed as ordinary income. The company generally withholds taxes at the time of vesting. If an employee sells their stock later, any gain will be taxed at the capital gains rate.

3. Vesting and liquidity

Both stock options and RSUs typically have vesting schedules, but their flexibility can differ.

Stock options: With stock options, employees eventually choose whether or not to exercise the options to acquire the shares. Employees who exit the company before exercising their options often forfeit their unvested options, and employees may have a limited timeframe to exercise options after leaving the company, before the options expire.

RSUs: Once RSUs vest, employees own the stock outright. Those who leave their companies typically retain any vested equity.

4. Risk versus reward

Another key consideration when looking at the difference between stock options versus RSUs is the level of risk involved:

Stock Options: If the stock price doesn’t exceed the exercise price, the options hold no intrinsic value. But stock options have the potential to outperform if the company thrives and the stock price climbs.

RSUs: Since employees receive the shares outright once they vest, even if the company’s stock price declines the stock retains some value (although the tax paid on the RSUs may have been based on a then-higher market value).

Which is better for startup employees?

Now that we’ve outlined the key differences, you may be wondering, “which is better for me—stock options or RSUs?” The answer often depends on tax considerations. That’s because stock options offer more flexibility in timing tax events (exercise and sale), while RSUs are taxed as ordinary income at vesting, with no control over the tax timing. Incentive stock options can offer substantial benefits, especially for those eligible for long-term capital gains treatment. However, RSUs are easier to manage because they don’t necessitate any action on the employee’s part to exercise.

Conclusion

If given the choice, selecting stock options versus RSUs may depend on an employee’s risk profile, long-term financial goals and the level of confidence one has in the prospect of a given startup’s success. Each type of equity compensation has its unique advantages and disadvantages, and knowing these differences can go a long way in helping you choose wisely. As always, you should consider consulting a financial professional when making such important decisions.

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