Employee Stock Options and RSUs: Understanding the Basics
As an employee, you may have heard about stock options or restricted stock units (RSUs) as part of your compensation package. These are forms of equity compensation that offer employees a way to own a piece of their company while also potentially benefiting from its success. In this post, we’ll explore the basics of both employee stock options and RSUs so that you can better understand how they work and what they mean for you.
Employee Stock Options
Stock options give employees the right to buy a certain number of shares in their company at a predetermined price, known as the strike price. The idea behind stock options is that if the company does well and its stock price increases over time, then employees who hold those options will be able to sell them for a profit.
There are two types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). ISOs are typically offered to executives or key employees, while NSOs are more commonly offered to all employees.
One advantage of ISOs is that they receive special tax treatment under U.S. tax law. If you exercise an ISO and hold onto the underlying shares for at least two years after it was granted (and one year after exercising), any subsequent gain will be taxed as long-term capital gains rather than ordinary income. This means lower taxes on any profits made from selling these shares.
However, there’s also risk involved with holding onto ISOs too long – if the company’s share price drops significantly before you sell your shares, then your investment could lose value quickly.
For NSOs, there’s no special tax treatment like there is with ISOs; instead, when an employee exercises an option they must pay taxes on any difference between the strike price and current market value as ordinary income. This can result in higher taxes depending on how much appreciation has occurred since receiving the option grant.
One key thing to keep in mind with stock options is that they usually come with an expiration date, meaning that you have a limited amount of time to exercise your options before they expire. This can be anywhere from 5-10 years after the grant date, depending on the terms of your individual option agreement.
Restricted Stock Units (RSUs)
RSUs are another form of equity compensation where companies offer employees shares of company stock as part of their compensation package. Unlike stock options, however, RSUs don’t give employees the right to buy shares at a discounted price – instead, RSUs represent actual ownership in the company.
When an employee receives RSUs, they typically vest over a period of time (usually three to four years), meaning that you won’t actually own all granted units until some predetermined point in the future. Once they do vest and become fully owned by an employee, he or she can choose whether to hold onto them or sell them for cash.
One major difference between RSUs and stock options is how taxes are handled. When an employee receives RSUs and they vest into actual shares, it’s considered taxable income – just like receiving cash as part of your salary would be. As such, employers are required to withhold taxes on any vested RSU grants when they’re distributed.
Another potential downside with RSUs is that there’s no way for employees to control exactly when these units will convert into actual shares. If you’re granted 1,000 RSUs that vest over four years but leave the company after two years (before all units have vested), then you’ll only receive half those units – rather than having any control over timing this conversion process yourself.
Which Option Is Better?
Both stock options and restricted stock units can be valuable parts of an overall compensation package for employees who receive them. However, which one is “better” really depends on what you’re looking for from your equity compensation program.
Stock options can be a great way to align your financial interests with those of the company, since you’ll only make money if the stock price increases. However, there’s also a lot of uncertainty involved in holding onto stock options for too long – and if the company doesn’t perform as well as expected, then your investment could lose value quickly.
On the other hand, RSUs offer more certainty since they represent actual ownership in the company rather than just an option to buy shares at a discounted price. However, RSUs are taxed differently than stock options (as mentioned above) and carry their own risks such as not being able to control when units vest into actual shares.
Ultimately, it’s up to each individual employee to decide which type of equity compensation makes sense for them based on their personal goals and financial situation. It may be helpful to talk with a financial advisor or tax professional who can help you understand both types of equity compensation more fully before making any decisions about how to proceed.