Stock Options and RSUs: What You Should Know
Today, many compensation packages extend beyond the traditional mix of a regular paycheck and end-of-year cash bonus. Employees now often receive an equity stake in their employer, most typically through stock options or restricted stock units (RSUs). This supplemental compensation can be significant, but it also carries additional complications, unpredictability, and tax consequences.
Due to the complexity of equity awards, you should consider many issues when you evaluate potential job prospects or manage the benefits of your current position. At some companies, like Proctor & Gamble, employees can decide how to split their equity stake between RSUs and stock options. Although this degree of latitude is relatively unique, examining such plans can powerfully illustrate the relative pros and cons of these forms of equity compensation.
At Truepoint, we have worked with numerous clients, enrolled in dozens of equity award plans, and helped them optimize their plan to meet their specific long-term objectives. An equity award plan is one piece—albeit a very important piece—of a larger investment portfolio and long-term financial plan, including a tax strategy, and a financial advisor can help you align your company’s plan with your goals.
What Exactly Are Stock Options and RSUs?
Before we delve more deeply into the relevant issues, let’s quickly review what stock options and RSUs are. For a more comprehensive examination of these instruments, check out stock options and restricted stock units (RSUs) on Investopedia.
- Stock Options – A stock option gives you the right to buy a specific number of equity shares at a pre-determined price, known as the “strike” or “grant price.” Once your options vest, you can decide whether you’d like to buy the stock in question at the strike price. You only have a specified amount of time to exercise these options, but within that period, you can decide when to purchase shares.
- Restricted Stock Units (RSUs) – RSUs represent an employer’s promise that you will receive a specific number of equity shares on a particular date. When RSUs vest, you receive the number of shares promised. You then own those shares and can treat them like any other investment.
In sum, stock options give you the option to purchase company stock at a specific price before a certain date. Whether you actually purchase the stock is up to you. RSUs, on the other hand, grant you the stock itself. You don’t have to decide anything, and they don’t expire like options do.
Comparing Stock Options and RSUs
There is no universal rule about whether stock options or RSUs are better. Both instruments carry specific risks that you should consider as you evaluate their pros and cons for you.
Valuation Risk
Most employees especially want to know the upside potential for each type of award. Stock options are more sensitive to market fluctuations because their value depends on the company’s stock price. With options, you can strategize the timing of your purchase so that, when timed right, they can generate exponential rewards. On the other hand, if the stock price falls below the exercise price, then your options have no real value.
Imagine an employee with the option to buy their employer’s stock at $25/share. When their options vest, the stock is selling at $50/share. That means they can purchase shares at half the price that other investors must pay; they essentially double the value of their option. On the other hand, if the stock ends up selling for $20 per share, then their option is essentially worthless; they could buy the stock for less on the open market.
Alternatively, with RSUs, the risks of a declining share price are lower. RSUs will retain value as long as the employer’s stock retains value. As a result, RSUs are generally lower risk than options, but their upside potential is also less.
Tax considerations
Stock options and RSUs are also taxed differently. In the US, stock options typically trigger taxes upon exercise, and employees generally owe taxes on the difference between the market price and the exercise price. The type of stock option and the holding period affect the tax rate.
In contrast, RSUs are taxed upon vesting. They are taxed like ordinary income, and their value on the day of vesting is the value used for tax calculations. Taxes are then withheld accordingly. Any subsequent appreciation or depreciation in the stock’s value is subject to capital gains tax upon sale.
Tax rules on equity awards vary from country to country and carry different implications for each individual. This summary is intended to help you understand some general tax implications to consider, but you should speak to a tax specialist to understand exactly how your equity award will affect your tax bill.
Investor engagement
Stock options demand more management than RSUs. With RSUs, you are awarded shares after a vesting period; they then require the same amount of management as any other investment. With stock options, you must actively decide if and also when to exercise your options. For any shares you purchase, you then have the same responsibilities as with RSUs; you manage them like any other investment.
Concentration risk
Stock incentive plans are designed so that you share in the financial success that you create. But they increase your level of financial investment in the company you work for. Whenever you receive stock from your employer, it is critical that you monitor your concentration risk—the amount of your portfolio (or more broadly, your wealth) tied to one company. If not, your wealth can become increasingly tied to the performance of one stock and increase your concentration risk to an imprudent level. As such, all equity awards require some degree of engagement, even if you are passively granted the shares.
| RSUs | Stock Options | |
|---|---|---|
| Event Timing | You know when they will be granted, but you cannot control the timing of delivery or the tax event | You choose timing of the investment and tax event |
| Valuation | Will retain some value, as long as stock price does not drop to $0 | Potential for greater value, but can be worthless if the stock price falls below grant price |
| Risk | Less risky | More risky |
| Investor Engagement | Less engagement required; you receive shares automatically | More engagement—you must exercise the options |
| Expire? | No—after vesting, you own outright | Yes—only good for certain period |
Understand the rules and contingencies
Stock awards are governed by the specific rules and structures of your employer’s plan. Make sure you read the supporting materials carefully. Pay careful attention to what happens in important life circumstances, even events you don’t anticipate, including retirement, termination, distribution of marital assets, disability, and company merger or acquisition. For example, at Proctor and Gamble, during your first three years of employment, both stock options and RSUs are forfeitable if you resign or are terminated for cause.
Understanding the complexities and implications of stock options and RSUs is crucial for reaping the benefits of equity compensation. Both instruments have advantages and disadvantages. It’s crucial to consider your own situation and objectives when assessing them. In part two of this series, we will delve into how Proctor & Gamble employees can structure their LTIP award to align with their long-term objectives.
