Stock Options vs RSU - The Ultimate Guide
What's the difference between Stock Options and RSUs? This ultimate guide to stock options vs RSU covers everything you need to know to become a savvy investor. In the past years, many Silicon Valley tech companies have used company stock incentives such as restricted stock units and stock options.
Many of the Silicon Valley startups are using these equity compensation programs as a cost-effective employee benefit plan so they can have loyal employees.
In the financial world, many tech-savvy investors believe that Facebook has increased the popularity of RSU stock options. In 2007, Microsoft decided to invest in Facebook $200 million at a $4 billion valuation. The extremely high valuation made it hard for Facebook to attract new employees until they offered them more attractive RSUs agreements.
We often hear from our trading community, and from our experience, it’s very likely that you don’t know what is a restricted stock unit. In this step-by-step RSUs guide we’re going to outline what decisions you have to make to profit from buying restricted stock units.
In part one of this stock options vs RSU guide, we’re going to cover what are RSUs and what is the difference between RSU and stock options.
What Are Restricted Stock Units?
Simply put, restricted stock units (RSUs) are a grant of company stock that’s yours once it’s vested. We understand that at this point you may scratch your head with all these new technical terms. We’re going to take it step-by-step to shed some light on.
To make the explanation of the RSU stock option more interactive, let’s use our imagination and follow the typical storyline of the Millennial generation:
Let’s suppose Joe has just landed a job at a big company. This company is a large publicly-traded tech company from which Joe will be compensated with some shares that he can’t sell just yet. These shares Joe gets are called restricted stock units or RSU.
Also, learn how to Swing Trade Options here.
The date Joe receives these restricted stock units is called the grant date. However, Joe can’t sell the RSUs until certain conditions have been met. This is due to a vesting schedule that the tech company has set forth before Joe can sell his shares.
The tech company has two options on how they can structure the vesting schedule:
- Gradual schedule – is a type of vesting in which Joe can receive small portions of vesting over a period of 3 to 5 years. If, for example, Joe’s tech company uses a five-year schedule, then Joe will receive 20% of the shares each year.
- Cliff schedule – is a type of vesting in which Joe can receive the entire share vested after a stated service period. In cliff vesting, Joe will receive the full shares after he typically worked a certain number of years. The number of years worked is discussed when Joe negotiates his overall compensation package.
This is a win-win situation for both the employee Joe and the employer, the tech company. On the one hand, the tech company can ensure Joe will work for the company for a long period of time. This typically means higher productivity and subsequently bigger profits.
On the other hand, Joe can be motivated to work for the tech company and have a bigger paycheck once vested and sold. Joe is obligated to work for the tech company during the specified vesting schedule in order to own the shares.
The need to vest is what makes an RSU stock option restricted.
When the shares vest, Joe can either sell the shares, hold the shares if he believes the stock price has the potential to go a lot higher, or a combination of the two.
As the name suggests, RSUs are a restricted form of shares or restricted certificate of stock. In the financial world, RSUs are also known as letter stock or restricted securities.
Example of How RSUs Work
Let’s assume Joe gets 1,000 shares when the stock price was at $10 a share. Joe also agrees to a gradual vesting period of 4 years, which means he will be able to vest 250 shares each year during the 4 year vesting period.
At the end of year one, the stock price is $11 a share. The 250 shares vested are now worth $2,750 (250 shares x $11).
Let’s assume that at the end of year two, the stock price depreciates to $9.50 a share. The other 250 shares vested are now worth $2,375 (250 shares x $9.50).
*Note: The difference between RSU vs stock options is that even though the stock price is lower than the price at the grant date, your shares still have value based on the current market price.
At the end of year three when the third slice of 250 shares vests, your stock price has appreciated to $15 a share. These shares are now worth $3,750 (250 shares x $15).
Now, in the last year of the vesting period when the last 250 shares vast the stock price continued to appreciate, it’s now trading at $20. These shares are now worth $5000 (250 shares x $20).
The initial 1,000 shares of RSU resulted in $13, 875 profit or net income for you.
Let’s take a look through the eyes of the same example and see what is the difference between stock options vs RSU.
Instead of receiving RSUs you get from your employer's 1,000 shares worth of stock options. Considering all things equal with the previous example, at the end of year four, you get back $20,000 (1,000 shares x $20).
What is the Difference Between RSU and Stock Options
The difference between RSU and stock options is that the RSUs limit the downside, but they also limit the upside. On the other hand, stock options maximize the upside and they expire worthless if the stock price doesn’t move above the grant price during the vesting schedule.
The restricted stock units can also be structured in such a way you can have all the benefits of stock options. In this sense, between RSU vs stock options, RSUs are more versatile than stock options.
The final major difference between RSU and stock options is the way they are taxed. The RSUs are taxed based on the ordinary income rates. However, stock options have a more complex taxation system. Learn how to avoid tax traps of RSUs here.
Restricted Stock Units vs Options
Companies can decide between restricted stock units vs options part of your compensation plan. Stock options are another common form of equity compensation. This is an agreement that provides the terms under which you can buy a specific number of shares at a set price. The hope is that the value of the company and therefore the shares increase over time.
Now, if the stock price depreciates you don’t lose anything because you don’t own those shares. You simply have an option to buy them.
This is like a free lunch!
You have the upside advantage and the profit potential if the share price appreciates. However, if the stock price depreciates you don’t lose anything.
You may also like this guide on futures vs options advantages.
We can distinguish two types of stock options:
- Incentive stock options or ISO.
- Nonqualified options.
There is no need to get deeper into this topic, we just want to lay down the foundation, building a base to help you accumulate wealth.
The Pros and Cons of Restricted Stock Units
Since there is a lot of confusion on the RSUs advantages we’re going to outline the pros and cons of RSUs. The main benefits of restricted stock units are:
- Both the employee and the employer will want the company to succeed.
- The employee can earn extra compensation for his work.
- The more the stock price rises, the more money you can make.
The restricted stock units can also have some cons:
- The restricted stock units tax is an income tax.
- If the stock price falls, you can earn less money.
- You can also lose unvested shares at termination.
Be sure to test your strategies with this Paper Trading Options Tutorial.
Conclusion – Stock Options vs RSU
As an investor, you have to ask yourself if weren’t employed by a particular company, would you go on the open market and buy those shares yourself? Often times when you work for a company, you can be emotionally attached to that company and this might bias your view on how much the stock is worth.
It can happen that the company you work for, especially if it’s a startup, to have the stock price increased considerably. If the company you work for becomes a giant tech company and you never sold your shares in the process at the end you can make millions of dollars in profit.
For more information on options trading, read this training on How to Trade Stock Options for Beginners.
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