Stock Options vs RSU – The Ultimate Guide
What is the difference between Stock Options and RSU? This ultimate guide to stock options vs. RSU covers everything you need to know to be a savvy investor. Over the years, many Silicon Valley tech companies have used corporate stock incentives such as limited stock units and stock options.
Both stock options and RSU can make your trading strategy more dynamic. 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 Facebook has increased the popularity of RSU stock options. In 2007, Microsoft decided to invest in Facebook $200 million at a valuation of $4 billion. The extremely high valuation makes it difficult for Facebook to attract new employees until they offer them more attractive RSU deals .
We often hear from our trading community and from our experience you most likely don’t know what a restricted stock unit is. In this step-by-step RSU guide, we’ll outline the decisions you must make to profit from buying units of restricted stock.
In part one of this stock option versus RSU guide, we will cover what RSU is and the difference between RSU and stock options .
What are restricted stock units?
Simply put, “restricted stock units” (RSU) are an allowance for company stock that you have assigned. We understand that at this point, you’re probably scratching your head with all these new technical terms. We will take steps to shed light on this and related topics.
To make the RSU stock option explanation more interactive, use our imagination and follow the typical Millennial plot:
Let’s say Joe has just landed a job at a large company. The company is a large publicly traded technology company, from which Joe will be compensated with some shares that he cannot yet sell. These shares Joe receives are called limited stock units or RSUs.
Also, learn how to rotate trade options here .
The date Joe receives these limited stock units is called the issue date. However, Joe cannot sell RSU until certain conditions are met. This is because of a schedule the tech company has set before Joe can sell his shares.
Tech companies have two options for how they can structure their veting schedule :
- Gradual Schedule – is a type of vesting where Joe can receive a small portion of the vest over a period of 3 to 5 years. For example, if Joe’s technology company uses a five-year schedule, then Joe will receive a 20% share each year.
- The Cliff schedule- is a type of vesting in which Joe can get the entire stake delivered after a stated service period. In cliff vesting, Joe will receive the full stake after he normally works a certain number of years. Years of service are discussed when Joe negotiates his overall compensation package.
This is a win-win situation for both the Joe employee and the employer, the tech company. On the one hand, the tech company can make sure Joe stays with the company for a long time. This usually means higher productivity and subsequently greater profits.
On the other hand, Joe might be motivated to work for the tech company and get a bigger salary once delivered and sold. Joe is obligated to work for the tech company on a specified trading schedule in order to own shares.
The need to wear a vest is what makes an RSU stock option so limited.
When the stock is delivered, Joe can sell the stock, hold the stock if he believes the share price has the potential to move much higher, or a combination of the two.
As the name suggests, an RSU is a form of restricted stock or restricted stock certificate. In the financial world, RSUs are also known as letter securities or restricted securities.
Example of how RSU . works
Assume Joe receives 1,000 shares when the stock price is at $10 per share. Joe also agrees to a gradual vesting period of 4 years, which means he will be able to receive 250 shares per year over the course of 4 years of vesting.
At the end of year one, the stock price was $11 per share. The 250 shares delivered are currently valued at $2,750 (250 shares x $11).
Assume that at the end of the second year, the stock price depreciates by $9.50 a share. The other 250 shares delivered are currently valued at $2,375 (250 shares x $9.50).
*Note: The difference between an RSU and a stock option is that even though the share price is lower than the price at the grant date, your stock is still worth based on the current market price.
At the end of the third year when the third slice is 250 shares, your share price has increased to $15 per share. These shares are currently worth $3,750 (250 shares x $15).
Now, in the final year of the last 250 shares trading period, the stock price continues to appreciate, now trading at $20. These shares are now worth $5000 (250 shares x $20).
The initial 1,000 shares of RSU gives you a profit of $13,875 or net income.
Let’s go through the eyes of the same example and see the difference between stock options vs RSU .
Instead of getting RSU, you get from stock options 1,000 worth of employer shares. Considering all things equal to the previous example, at the end of the fourth year, you get back $20,000 (1,000 shares x $20).
What is the difference between RSU and Stock Options
The difference between an RSU and a stock option is that RSUs limit the downside, but they also limit the downside. On the other hand, stock options maximize upside and they expire worthless if the stock price does not exceed the level price in the trading schedule.
Restricted stock units can also be structured in such a way that you can have all the benefits of stock options. In this sense, between RSU and stock option, RSU is more flexible than stock option.
The final major difference between RSU and stock options is how they are taxed. RSUs are taxed at the rate of ordinary income. However, stock options have a more complex tax system. Learn how to avoid the RSU tax trap here .
Limited stock unit vs option
Companies can decide between limited stock units versus options in your compensation plan. Stock options are another popular form of equity compensation. This is an agreement that provides 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 stock increases over time.
Now, if the stock price depreciates, you lose nothing because you don’t own those shares. You just have an option to buy them.
This is like a free lunch!
You have the upside advantage and the potential to profit if the stock price goes up. However, if the stock price depreciates, you lose nothing.
You might also like this guide about futures and options.
We can distinguish two types of stock options:
- Preferred stock options or ISO.
- Unqualified option.
No need to delve deeper into this topic, we just want to lay the groundwork, build a foundation to help you accumulate wealth.
Pros and cons of restricted stock units
Since there is a lot of confusion about the advantages of RSU, we will outline the pros and cons of RSU. The main benefits of restricted stock units are:
- Both employees and employers will want the company to succeed.
- Employees can earn extra compensation for their work.
- The higher the stock price, the more money you make.
Limited stock units can also have some disadvantages:
- The restricted stock unit tax is an income tax.
- If the stock price falls, you can make less money.
- You may also lose uninvested shares upon termination.
Conclusion – Stock Options vs. RSU
As an investor, you must ask yourself, if not employed by a particular company, would you go into the open market and buy those shares yourself? Often when you work for a company, you can become emotionally attached to that company and this can distort your view of the value of that stock.
It can happen that the company you work for, especially if it’s a start-up, causes the stock price to rise significantly. If the company you work for turns out to be a giant tech company and you never sell your shares in the process in the end, you could make millions of dollars in profits.