Stock Options vs. RSU - What’s the Difference?

If you’re looking to become one of the most successful investors out there, then this guide is what you should be reading. It includes all the dynamics that you should know regarding stock options vs RSU. Over the last decade, some of the biggest players in Silicon Valley have been taking full advantage of company stock incentives like stock options and restricted stock units.

As a way of maintaining the loyalty of their employees, the companies operating in Silicon Valley are making use of these equity compensations to improve their employee benefits and mind you, it’s very cost-effective.

Most of the savvy investors now think that Facebook has contributed to the increased popularity of RSU stock options in the financial world. Under a $4 billion valuation, Microsoft decided to invest $200 million in Facebook back in 2007. Given the high valuation, it became hard for Facebook to make loyal employees. This was until they offered them appealing RSU agreements.

Based on our own experience and what we hear from the trading community, chances are high that you have no idea what a restricted stock unit is. We have outlined, in this guide, all you need to do to profit from investing in restricted stock units.

What Are Restricted Stock Units?

Basically, a restricted stock unit is a grant of company stock whose ownership is transferred to you once it has been vested. We know that all these new technical terms might cause a slight scare in you but don’t worry; we’ll take it slowly until you get it all.

For the purpose of making this conversation about what is RSU stock option lighter and more interactive, let’s bring in our imagination and basically follow the well-known Millennial generation storyline.

Suppose a guy named Joe just started working at a big company. The company deals with technology and is publicly traded. Joe has been awarded shares that he can’t sell, at least not yet. These shares that Joe gets are what we are referring to as restricted stock units or RSU.

The grant date is the exact day that Joe receives these shares. If Joe desires to sell his shares, certain conditions must be met first. This is attributed to the vesting schedule that the company has decided on before Joe can release his shares.

The company has two methods through which they can create this vesting schedule:

● Gradual Schedule – This is a type of vesting through which the employee can get small portions of his shares over a timeline of 3-5 years. Say for instance the company follows a 5-year schedule, then Joe will get a fifth of the shares per year.

● Cliff Schedule - In this type of vesting, it’s possible for Joe to receive all the vested shares after a predetermined service period. Typically, he will receive his shares after he has worked in the company for a certain number of years. The number of years will be determined after Joe’s compensation package has been fully negotiated.

For both the tech company and Joe, this is a win-win situation. For one, the tech company will be assured that Joe will stick around for a long time. This translates into more outcome from the company and ultimately more profits will be made.

On Joe’s side, motivation will not be an issue. He will be assured of a bigger paycheck once his shares are vested and sold. He will also be under the obligation to stay with the tech company for the specified vesting period to win those shares.

An RSU stock option is made restricted by the need to vest it.

Once Joe has the shares in his name, he can decide to either sell them or hold them if he is of the opinion that the price will go up. He can also do a combination of the two.

RSUs, just as the name suggests, are just a restricted certificate of stock or a restricted form of shares. They are also referred to as restricted securities or letter stock in financial terms.

What Are Stock Options?

A stock option is basically a contract between two parties which allows the buyer to either buy or sell underlying stocks within a specified period of time and at a predetermined price.

An option writer is the seller of the stock option. The seller is usually paid a certain amount of money from the contract purchased by the buyer of the stock options.

There exist two types of stock options:

● A stock call option that gives the buyer the right to buy stock. However, he’s not obliged to do so. When the price of the underlying stock rises, the stock call option increases in value.

● A stock put option that gives the buyer the right to short sell the stock. When the price of the underlying stock drops, a put option increases in value.

You will find that investment bankers usually buy both types of options either individually or as a combination so that they can employ certain trading techniques, as well as a covered call.

Most households have a scrambled Rubik’s Cube that has never been solved. Use the Rubik’s solver to calculate the solution in only 20 steps!

How RSUs Work

Let’s get back to Joe and assume that he has been given 1,000 shares, each valued at $10. Joe goes ahead and agrees to a 4-year vesting period. This means that at the end of every year he will be receiving 250 shares for the 4-year vesting period.

At the end of the first year, the price of one share goes up to $11. His 250 shares are now worth $2,750 ($11*250 shares.)

Now assume that at the end of the second year, the price of one share goes down to $9.50. The now vested 250 shares are worth $2,375 ($9.50*250 shares.)

Please keep in mind that the major difference of RSU, when compared to stock options, is that despite the stock price is lower than that at the grant date, the value of your shares is evaluated according to the current market price.

At the end of the third year, once the third quarter of Joe’s shares is vested, the stock price has shot up to $15. Therefore, the price of his shares will be $3,750 ($15*250 shares.)

We are now in the last year, and the final 250 shares have been vested. The price has appreciated to $20 per share. The final shares are now worth a total of $5,000.

From the calculations, the resulting profit (or new income) from the first 1,000 shares of RSU will amount to $13,875.

Once again, let’s cut through the same example and see the difference between RSU and stock options. 

As opposed to receiving RSUs from your employer, you get 1,000 shares in stock options. Taking all things to be equal as in the example above, you will receive $20,000 at the end of the 4-year period (1,000 shares x $20)

The Difference Between Stock Options and RSU

The major difference between the stock options and the RSU is that RSUs limit the downside. However, they also put a limit on the upside. Stock options, on the other hand, maximize the upside.

The RSUs are advantageous since there’s a way through which you can structure them to give you all the benefits of stock options. From this perspective, given both RSUs and stock options, RSUs are more flexible than stock options.

The third major difference between the two (RSU and stock options) is their method of taxation. The RSUs are taxed by the regular income rates. On the other hand, the taxation of the stock options is more complex.

Options vs. Restricted Stock Units

As part of your compensation plan, companies can settle on either options or restricted stock units. Stock options are just another form of equity compensation (quite common, actually). It’s an agreement that gives the terms that a buyer should comply with to purchase some shares at a particular price. The hope here is that the company’s value will increase over time, as will the shares.

There will be no losses for you if the share price depreciates since you don’t own the shares after all. The only option available to you is to buy them.

Look at it like free pizza!

If, however, the share price appreciates, you have the potential for profit as well as the upside advantage. You will not lose anything if the price drops.

There are two types of stock options:

● Non qualifies options

● Incentive stock options (ISO)

While we may not feel the need to delve deeper into the two types, we will just lay the foundation for you that will enable you to build a base that will be instrumental in building wealth.

Advantages and Disadvantages of Restricted Stock Units

There’s usually too much confusion on the advantages of RSUs. We are, therefore, going just to give you the pros and cons of RSUs.

Here are the main benefits of restricted stock units:

● Both the company and the employee have the same objective; to see the company succeed.

● The employee will be earning extra cash for his work.

● The higher the price of the stock goes, the more your profits will increase.

The restricted stock units also have their cons:

● Restricted stock units are taxed based on the income.

● You face the risk of earning less money if the stock price goes down.

● You also face the risk of losing your vested shares if you’re terminated.

A Primer on Equity Compensation

The number of instruments used for incentives in equity has steadily increased over time. With more choices, comes more complexity. The advantage with this is that there will also be more choices.

Below, we have outlined some of these instruments:

● Stock Options - They give you the right to purchase a company’s stock sometime in the future at a price that will be set now. You might be set to make huge profits in the future if high-growth companies can very well surpass their current value by great lengths. Once you exercise your shares, you become an official company shareholder.

● Restricted Stock - This is just stock on which restrictions have been placed, and payment isn’t really necessary. In most cases, it’s just normal stock that has been vested. The holder cannot sell this stock until it has vested. If one is terminated, the company reserves the right to repurchase all the unvested shares. A restricted shareholder is officially a shareholder in the company.

● Restricted Stock Units - They are a commitment by the company to give some shares after a certain period of time. Payment isn’t usually required. Some conditions have to be met, however, before the holder of the shares can be handed the predetermined value. A settlement of the same might be in the form of the stock or the cash value of the shares. Once a holder receives the stock, they are now officially a company shareholder.

● Stock Appreciation Rights - These are cash or stock bonuses based solely on the performance of the company’s stock over a certain period of time. A holder of such is not an official shareholder.

● Phantom Stock – It’s cash or stock bonus that signifies holding a company’s stock over some time. It is, however, not stock, so one isn’t really a stockholder.

● Profits Interests - They are basically a claim to an LLC with an increase in value over time. Their availability is limited to LLCs. Public companies employ most of these tools while private corporations use only restricted stock and stock options.

Conclusion

If you’re an investor, you need to ask yourself if you would one day go out there and purchase these stocks if you weren’t employed by a particular company. In most cases, emotional attachment to your company might arise, and this might create a bias in you regarding the price of a stock.

An instance may occur where the company you work for, if it’s a startup, especially, increases the stock price significantly. If it one day becomes a giant in its field and you never sold your shares, you stand the chance of making millions.