I had a recent call with a client who received a performance award and had the choice of taking Stock Options or RSUs. Throughout the “great upgrade,” several of our clients have transitioned to companies that offered stock signing bonuses, offering clients the choice between Options and RSUs.
If you are offered these options, which should you do?
What are RSUs?
Restricted Stock Units are a form of equity-based compensation which grant employees a pre-determined number of shares of company stock. This grant is subject to a vesting period. As shares vest, the employee can sell them or hold them indefinitely – they do not expire. Vesting schedules can vary, but typically they would vest over four years.
What are NSOs?
Nonqualified stock options are a grant of options that vest typically over four years. Once the options vest, give employees the right to buy a certain number of company shares at a specific price determined when the options were granted (grant price). Shares can be held or sold after exercise, but the stock options expire ten years after the grant date.
How do RSUs and Options compare?
Risk & Return
For stock options to have value, the company’s stock must increase above the grant price. If you are granted stock at $100 per share, and the stock stays at $99 per share for the ten years following the grant, the options expire worthlessly, and the employee receives no value. For RSUs in the same scenario, the employee still receives stock worth $99.
When the company’s stock exceeds the grant price, the value of NSOs and RSUs will differ. For stock options, the higher the stock price is above the grant price, the greater your gain. With RSUs, your value is fixed at the stock price at vesting.
To summarize the risk and return relationship between RSUs and Stock Options: Stock options offer a higher potential return, but they have the potential to expire worthlessly. RSUs, on the other hand, will have value as long as the stock price has value and your return matches the stock price at vesting.
Taxes
RSUs are taxed as ordinary income at the time they are vested. The amount of taxable income is equal to the market value of the vested shares.
With stock options, there is no tax liability at grant or vesting. Taxation occurs at exercise. The difference between the market price and grant prices is taxable income. Stock options allow people to plan to time the exercise and plan around the tax liability.
Which is best for you?
There are several variables an employee should consider when deciding how to receive equity-based compensation. Below are a few examples, but each individual will have other questions to consider as they make this decision:
- What is the current market price, and how will the grant price be determined?
- Will that set the grant price relatively high or low compared to possible future outcomes?
- Where is the employee in their wealth-building journey?
- How long do they plan to be with this employer?
Three hypothetical employee circumstances:
Mary
Mary is 60 and getting ready to retire next year. She has built ample savings and felt prepared to retire before receiving this equity award.
At Mary’s company, stock options continue to vest according to their schedule even if she is not working for the company. RSUs, on the other hand, do not.
For Mary, that means she can collect one year of RSUs and lose the remaining grant. Mary feels the company is headed in a good direction and feels that she is comfortable with the greater risk of stock options.
Clark
Clark is 45 years old. He recently took out a $100,000 home equity line of credit (HELOC) to finance a new pool. He wants to surprise the family with the news at Christmas!
Clark has savings in his 401k and 529s for the kids, but with his family and household costs, he does not have other significant savings. To pay off the HELOC, he is relying on his bonus.
For Clark, RSUs are likely the best choice. They offer a more planned and predictable source of income to meet the immediate cash needs. If instead, Clark chose options, the options could have no value at vesting, and he wouldn’t have the resources needed to pay off the loan and surprise his family with a pool.
Susan
Susan is 38. She is making more money than she is spending and has nearly $500,000 saved in her 401(k). She doesn’t have a significant emergency fund, but she also has no immediate cash needs.
Susan doesn’t have any investments outside of her 401(k). She recognizes that all her assets are in retirement accounts and are not very liquid. She wants to start building a diversified investment portfolio.
To create the investment portfolio, RSUs offer an element of certainty and the flexibility to sell the vested shares and build a diversified portfolio.
We’re here to help
When deciding between RSUs, stock options, or a mix of both, the correct answer will vary from person to person. An investor’s goals, risk tolerance, and tax implications are some of the tradeoffs to consider when selecting the right approach.
If you have questions or would like to discuss your options in greater detail, we are here to help.