Stock Options vs RSU – The Ultimate Guide
What is 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 recent years, many tech companies in Silicon Valley have taken advantage of corporate equity like restricted stock and stock options.
Both stock options and RSU can help make your trading strategy more dynamic. Many of the Silicon Valley companies use these equity compensation programs as a cost-effective employee benefit plan so that they can have loyal employees.
In the financial world, many tech savvy investors believe that Facebook has increased the popularity of RSU shares. In 2007, Microsoft decided to invest $200 million in Facebook at a valuation of $4 billion. The unusually high valuation made it difficult for Facebook to attract new employees until they offered more attractive RSUs deals.
We hear from our trading community often, and from our experience, it’s very likely that you don’t know what a restricted stock unit is. In this step-by-step RSUs guide, we’ll outline the decisions you need to make to take advantage of buying restricted stock.
In part one of this Stock Options vs RSU guide, we’ll go over what RSUs are, and what the difference is between RSUs and stock options.
What are restricted stock units?
Simply put, restricted stock units are an award of company stock that belongs to you once it vests. We understand that you may be scratching your head at this point with all these new technical terms. We are going to take it step by step to shed some light on this topic and related topics.
To make the layout of the RSU stock option more interactive, we use our imagination and follow the typical storyline of the Millennial generation:
Let us suppose that Joe has just got a job at a large corporation. This company is a large publicly traded tech company where Joe will be compensated with a number of shares that he cannot yet sell. These shares that Joe gets are called restricted stock units or RSU.
Also read here how to swing trading options.
The date Joe receives these restricted stock units is called the grant date. However, Joe cannot sell the RSUs until certain conditions are met. This is due to a vesting schedule that the tech company has set up before Joe can sell his shares.
The technical company has two options for structuring the establishment 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. For example, if Joe’s tech company uses a five-year schedule, Joe will receive 20% of the stock each year.
- Schedule – is a type of vesting in which Joe can receive the full share vested after a specified period of service. In the establishment of the cliff, Joe will receive the full shares after working usually a certain number of years. The number of years worked is discussed when Joe negotiates his overall compensation package.
It’s a win-win situation for both the employee Joe and the employer, the tech company. On the one hand, the technical company can ensure that Joe will work with the company for a long time. This usually means higher productivity and consequently greater profits.
On the other hand, Joe may be motivated to work at the tech company and have a bigger paycheck once it is established and sold. Joe is required to work for the technical company during the specified vesting scheme in order to own the shares.
The vesting requirement is what limits a stock option of the RSU.
If the stock settles, Joe can sell the stock, hold the stock if he believes the stock price has the potential to go much higher, or a combination of the two.
As the name suggests, RSUs are a restricted form of shares or a restricted stock certificate. In the financial world, RSUs are also known as letter stock or restricted securities.
Example of how RSUs work
Suppose Joe gets 1,000 shares when the stock price was $10 per share. Joe also agrees to a 4-year gradual vesting period, which means he can vest 250 shares per year during the four-year period.
At the end of the first year, the stock price is $11 per share. The 250 shares vested are now worth $2,750 (250 shares x $11).
Let’s assume that the stock price falls to $9.50 per share at the end of year two. The other 250 shares vested are now worth $2,375 (250 shares x $9.50).
* Note: the difference between RSU and stock options is that even if the stock price is lower than the price on the grant date, your shares still have value based on the current market price.
At the end of the third year, when the third part of 250 shares vests, your share price has risen to $15 per 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 were at large, the share price continued to rise, now trading at $20. These shares are now worth $5000 (250 shares x $20).
The initial 1,000 shares of RSU earned you $13,875 in profit or net income.
Let’s go through the same example and see what is the difference between stock options and RSU.
Instead of receiving RSUs, you get stock options worth 1,000 shares from your employer. All things being equal with the previous example, at the end of year four you will have $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 expire worthless if the stock price does not move above the grant price during the vesting schedule.
The restricted shares can also be structured so that you can have all the benefits of shares. In this sense, between RSU and stock options, RSUs are more versatile than stock options.
The last major difference between RSU and stock options is the way they are taxed. The RSUs are taxed based on the ordinary income rate. However, stock options have a more complicated tax system. Learn how to avoid tax traps of RSUs here.
Restricted stock units vs options
Companies can decide between restricted stock units and options as part of your compensation plan. Stock options are another common form of stock compensation. This is an agreement that contains 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 will increase over time.
If the share price goes down, you lose nothing because you don’t own the shares. You simply have the option to buy it.
It’s like a free lunch!
You have the benefit and the profit potential if the share price rises. However, if the share price goes down, you lose nothing.
You might also like this guide on futures and options benefits.
We can distinguish two types of stock options:
- Incentive options or ISO.
- Non-qualified options.
There is no need to get deeper into this topic; we just want to lay the foundation and build a base to obtain your wealth.
The advantages and disadvantages of restricted stock units
Since the benefits of the RSUs are a lot of confusion, we are going to break down the pros and cons of RSUs. The main advantages of limited stock units are:
- Both the employee and the employer want the business to succeed.
- The employee can earn extra compensation for his work.
- The more the share price rises, the more money you can earn.
The limited stock units can also have some disadvantages:
- The tax on restricted shares is an income tax.
- If the share price goes down, you can earn less money.
- You may also lose unaffiliated shares upon termination.
Conclusion – Stock Options vs RSU
As an investor, you have to ask yourself if you were not working in a particular company, would you go on the open market and buy the shares yourself? Often when you work for a company, you can become emotionally attached to the company, and this can affect your view of the value of the shares.
It may happen that the company you work for, especially if it is a start-up, increases the share price significantly. If the company you work for becomes a giant tech company and you end up never selling your shares, you could make millions of dollars.
For more information on trading options, read this training on How to Trade Stock Options for Beginners.
Thanks for reading!