Two of the most common employee stock plans, employee stock options (ESOs) and restricted stock units (RSUs), both give you the chance to eventually become a shareholder in your company. While these benefits may sound very similar, there are significant differences between them.
An employee stock option is the promise that, at a future date, an employee has the option to buy company stocks at a certain price. A restricted stock option is the promise that, at a future date (or upon the accomplishment of another milestone or benchmark), an employee will receive company stocks.
An employee stock plan may be offered to everyone as a companywide benefit. Other times, it’s a custom plan that’s baked into an executive job offer as either a recruitment and retention incentive, a way to cover the lack of cash flow in a startup, or both. Sometimes, employees get a choice between ESOs and RSUs. Understanding how each stock plan works, how they differ and exactly what the risks are with each can help you make a decision that best aligns with your financial goals.
This guide outlines the key features of ESOs and RSUs and breaks down the differences between them, so you can better decide what’s right for you.
Employee Stock Plans: Key Terms and Phrases
Having a grasp of stock market vocabulary can help you decipher quickly what your employer is offering, the terms and restrictions and whether it’s a good deal for you.
The Grant/Strike/Exercise Price
These are three different words with the same meaning: grant, strike and exercise price all refer to the price at which your plan says you can purchase company stock. It’s most often based on the stock’s current market value. If your strike price is 1,000 shares at $1 per share, for example, that’s what you’ll pay for those shares if you decide to exercise your stock options, regardless of their current market price.
Being ”In the Money” and “Out of the Money”
When the stock is currently trading above the strike price, it’s called being “in the money” and may mean big profits. Conversely, if the stock’s market price falls below the strike price, your options are considered “underwater” or “out of the money” and don’t hold any value. In that situation, it may be cheaper to buy your company’s stock on the open market.
What Are Employee Stock Options (ESOs)?
An ESO is an option to buy shares in your employer company in the future for a price set today. The “option” part means you can buy the stock later if it suits you, but you aren’t obligated.
Unlike an outright stock purchase, an option doesn’t give you actual shares until you decide to buy them, which is called exercising. Another difference from a traditional stock purchase is that options become null and void if you don’t exercise your stock options before the expiration date.
How do ESOs Work?
Generally, ESOs operate in four stages, starting with the grant date (aka strike date or exercise date) and ending with the exercise, or actually buying the stock.
1. The grant date. This is the official start date of an ESO contract. You receive official information on how many shares you’ll be issued, the strike price (aka grant price or exercise price) for those shares, the vesting schedule, and any requirements that must be met along the way.
2. The cliff. If a compensation package includes ESOs, it doesn’t necessarily mean that they’re available on day one. Contracts often contain a number of requirements that must be met first, such as working full time for at least a year. Those 12 months when you are not yet eligible for employee stock options is called the cliff. If you remain an employee past the cliff date, you get to level up to the vest.
3. The vest. When you pass your cliff date, your vesting period begins, which means you start to take ownership of your options and the right to exercise them. Vesting can either happen all at once or take place gradually over several years, depending on your company’s plan.
One common vesting schedule is a one-year cliff followed by a four-year vest. On this timeline, you’re 0% vested the first year (meaning you aren’t eligible for any options), 25% vested at the two-year mark (you can exercise up to 25% of the total options granted), and so on until you own 100% of your options. At that point, you’re considered fully vested.
4. The exercise. This is when you pull the financial trigger and actually purchase some or all of your vested shares. One common timeline is 10 years from grant date to expiration date, but specific terms will be in a contract.
Pros and Cons of Employee Stock Options (ESOs)
If you land a job with the right company and stay until you’re fully vested, exercising your employee stock options could lead to instant, huge gains. For example, if your strike price is $30 per share, and at the time of vesting the stock is trading at $100 or more per share, you’re getting a great deal on shares.
On the other hand, if your strike price is $30 per share and the company is trading at $10 per share, you might be better off not exercising your employee stock options.
Tax Implications of Employee Stock Options
Generally speaking, employers offer two types of stock options: nonqualified stock options (NSOs) and incentive stock options (ISOs). NSOs are the most common and often the type offered to the general workforce. NSOs are subject to income tax on the difference between the exercise price and the market price at the time you purchase the stock. (ISOs are “qualified”, meaning you don’t pay any taxes when you exercise the options—only when and if you sell them at a profit later on.)
Any money you make above and beyond that if you sell your shares later can also be subject to the capital gains tax. If you hold your shares less than a year, the short-term capital gains tax rate equals your ordinary income tax rate, which could be up to 37% for the highest tax bracket.
For assets held longer than a year, the long-term rate can be 0%, 15% or 20%, depending on your taxable income and filing status.
What Are Restricted Stock Units (RSUs)?
Restricted stock units, or RSUs, fall somewhere in between stocks and options—they are a promise of stock at a later date. When employees are granted RSUs, the company holds onto them until they’re fully vested.
The company determines the vesting criteria—it can be a time period of several years, a key revenue milestone or even personal performance goals. Like ESOs, RSUs can vest gradually or all at once.
How Do Restricted Stock Units (RSUs) Work?
RSUs are priced based on the fair market value of the stock on the day they vest, or the settlement date. This means that you don’t have to worry about falling out of the money—the company stocks you receive from your company will be worth just as much as they would be if you purchased them on your own that same day.
As long as the company’s common stock holds value, so do your RSUs. Upon vesting, you can either keep your RSUs in the form of actual shares or sell them immediately to take the cash equivalent. Either way, they will be taxed as income.
Pros and Cons of Restricted Stock Units (RSUs)
One good thing about RSUs is the incentive they can provide to stay with the company for a longer period of time. If your company grows during your vesting period, you could be very far in the money when your settlement date rolls around.
But even if the stock falls to a penny per share, they’re still awarded to you on your settlement date, and they’re still worth more than the $0 you paid for them. In fact, you may only lose out on money with RSUs if you leave the company and have to forfeit any units that aren’t already vested, or if the company goes out of business.
Tax Implications of RSUs
When your RSU shares or cash equivalent are automatically delivered to you on your settlement date(s), they’re considered ordinary income and are taxed accordingly. In fact, your RSU distributions are actually added to your W2.
For some people, the additional RSU income may bump them up a tax bracket (or two.) In those cases, if you’ve been withholding at a lower tax bracket before your vesting period, you could owe the IRS even more. As with ESOs, if you sell your shares at a later date and make a profit, you’ll be subject to capital gains taxes.
Knowing how ESOs and RSUs work—and understanding the differences between them in terms of terms, pricing and tax implications—can help you make an informed decision if and when you are offered one or both of these workplace perks.
Having the option to own stock in your employer company has the potential to provide attractive financial benefits, especially if you believe in the company and its future. However, one key investing strategy that many investors follow is portfolio diversification—making sure your investments are spread out across companies, industries and assets.
Here’s why: Because if all your investments are in company stock and the business folds or takes a downturn, you risk losing both your salary and your stock.
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