Stock options are not restricted stock units. That’s my big lesson from this week. I thought I knew what getting equity was all about, but given I’ve gone through few meaningful liquidity events other than Burner Rocket, I didn’t know what options truly meant. Burner Rocket, after all, was a much simpler transaction that my partner and I largely split.
Over the last couple startups I joined, I have been offered more significant stock options as part of my compensation. These were all early stage startups with great risk involved and lower-than-market salaries. I’ve realized the big difference of stock options while financial planning. Meanwhile, I have several friends who have joined companies and received restricted stock units (RSUs).
Here’s a quick breakdown about each.
Stock options are typically given as compensation and earned as a reward for hitting milestones with a company. They are typically earned over a vesting schedule. A common vesting schedule for modern startups:
- 1-year cliff – to mitigate the risk of new employees earning high-value options, companies instill a period that an employee must stay in order to start earning options. Stay 8 months, no options. Stay 1 year 8 months, options.
- 4 years – stock options are earned out over some time period where the 4 years includes the 1-year cliff. Typically, the earn out is evenly distributed over the years. If given 1,000 options, year 1 would earn 250 options. Year 2 would earn another 250 options (500 options, cumulative).
- Typically, after the 1-year cliff, options are earned every month (1/12th of the annual period, or 1/48th overall).
The key part about stock options is that they come with a strike price (or exercise price). This is a value per option usually based on the last valuation of the company. This is also the price to which a new employee has the right to acquire the options for at a later date when the options are earned (based on the vesting schedule).
For example, take a new employee can earn 1,000 options over 4 years. After 18 months, the employee earns the right to exercise her options on 375 options (18 x 1 / 48 x 1,000 = 375). The value of a share of stock is $50, but in her contract, she has a strike price of $0.50. This means she can exercise her shares of the company at $187.50 (375 shares x $0.50). However, the value of her shares are actually $18,750 (375 shares x $50). That would represent $18,562.50 in value earned.
Employees can exercise their stock options based on a contract. Read: employees cannot hold onto options forever and expect to exercise at forever + 1 day. They expire. Some startups may provide 3 months for employees to exercise following the voluntary or involuntary termination. There could also be no ability to exercise (o days) for termination with cause. This should be spelled out in the options agreement.
And finally, stock options come in two flavors:
- Nonqualified stock options – these options are extended to general employees, consultants, other partners of the company. No difference in value. The difference appears in taxes, to be discussed below.
- Incentive stock options – these options are typically reserved to executive management of the company (C-level managers and other key personnel). These individuals (via this type of stock option) receive preferential tax treatment (to be discussed below). Lawmakers wanted to provide another incentive for these leadership personnel who lawmakers believe bring greater value to the grander economy.
Restricted stock units
Restricted stock units (RSUs) are another way of saying shares of a company that have been reserved as compensation to an employee. RSUs, like stock options, may be earned on a vesting schedule–many, also, on 4-year schedules.
The big difference for RSUs is that they do not need to be purchased by the employee to own. Instead, employees earn them outright after vesting periods elapse. There is no strike price here. Instead, the number of shares would be earned based on the value of the stock at the time of earning.
Important to note here that RSUs could also mean earning the cash / liquidity of the value instead of owning the actual stock. This provides some flexibility to the employee on what and how to deploy her compensation.
The big differences
In short, RSUs are a safer, less volatile compensation type over stock options which require the employee to “buy” at an agreed upon strike price.
The other key difference between stock options and RSUs is how they are taxed.
For stock options, taxes are paid when the employee sells the shares. This will be based on the capital gains rate applicable. Additionally, if the stock options were marked as nonqualified (NSO), then, incomes taxes will also be assumed here.
RSUs, on the other hand, are treated as income as they are directly earned by the employee. As such, they incur the normal income tax on the market value of the earn out at the time of earning. Typically, the employer will withhold some number of shares (or cash) to pay the taxes rather than issues full to the employee and having the employee deal with the income tax implications. If the employee takes the option for stock shares, then capital gains taxes may be incurred if sold later than a year.
As you can see, stock options and RSUs are very similar in how they are used to compensate employees. The biggest differences are on risk (RSUs being the lower risk) and the way employees are taxed.