How Do Stock Options and RSUs Differ?

Man-Thinking
One of the biggest changes in the structure of Silicon Valley private company compensation over the past five years has been the increasing use of Restricted Stock Units (RSUs). I’ve been in the technology business more than 30 years and throughout that time stock options have almost exclusively been the means by which startup employees shared in their employers’ success. That all changed in 2007 when Microsoft invested in Facebook. To understand why RSUs emerged as a popular form of compensation, we need to look at how RSUs and stock options differ.

History of the Stock Option in Silicon Valley

More than 40 years ago a very intelligent attorney in Silicon Valley designed a capital structure for startups that helped facilitate the high-tech boom. His intention was to build a system that was attractive for Venture Capitalists and provided employees a significant incentive to grow the value of their companies.

To accomplish his goal he created a capital structure that issued Convertible Preferred Stock to the Venture Capitalists and Common Stock (in the form of stock options) to employees. The Preferred Stock would ultimately convert into Common Stock if the company were to go public or get acquired, but would have unique rights that would make a Preferred share appear more valuable than a Common share. I say appear because it was highly unlikely that the Preferred Stock’s unique rights, like the possibility of dividends and preferential access to the proceeds of a liquidation, would ever come into play. However, the appearance of greater value for the Preferred Stock allowed companies to justify to the IRS the issuing of options to buy Common Stock at an exercise price equal to 1/10th the price per share paid by the investors. Investors were happy to have a much lower exercise price than the price they paid for their Preferred Stock because it didn’t create increased dilution and it provided a tremendous incentive to attract outstanding individuals to work for their portfolio companies.

This system didn’t change much until around 10 years ago when the IRS decided that pricing options at only 1/10th the price of the most recent price paid by outside investors represented too large an untaxed benefit at the time of option grant. A new requirement was placed on companies’ boards of directors (the official issuers of stock options) to set option strike prices (the price at which you could buy your Common Stock) at the fair market value of the Common Stock at the time the option was issued. This required boards to seek appraisals (also known as 409A appraisals in reference to the section of the IRS code that provides guidance on the tax treatment of equity-based instruments granted as compensation) of their Common Stock from third-party valuation experts.

…build a system that was attractive for Venture Capitalists and provided employees a significant incentive to grow the value of their companies.

Issuing stock options with exercise prices below the fair market value of the Common Stock would result in the recipient having to pay a tax on the amount by which the market value exceeds the cost to exercise. Appraisals are pursued approximately every six months to avoid employers running the risk of incurring this tax. The appraised value of the Common Stock (and thus the option exercise price) often comes in at approximately 1/3rd the value of the latest price paid by outside investors, although the method of calculating the fair market value is far more complex.

This system continues to provide an attractive incentive to employees in all but one case – when a company raises money at a valuation well in excess of what most people would consider fair. Microsoft’s investment in Facebook in 2007 is a perfect example. Let me explain why.

Facebook changed everything

In 2007 Facebook decided to engage a corporate partner to accelerate its advertising sales while it built its own sales team. Google and Microsoft competed for the honor of reselling Facebook’s ads. At the time Microsoft was falling desperately behind Google in the race for search engine advertising. It wanted the ability to bundle its search ads with Facebook ads to give it a competitive advantage vs. Google. Microsoft then did a very savvy thing to win the Facebook deal. It understood from years of investing in small companies that public investors do not value appreciation earned from investments. They only care about earnings from recurring operations. Therefore the price Microsoft was willing to pay to invest in Facebook didn’t matter, so they offered to invest $200 million at a $4 billion valuation as part of the reseller agreement. This was considered absurd by almost everyone in the investment world, especially given that Facebook generated annual revenue of only $153 million in 2007. Microsoft could easily afford to lose $200 million given its greater than $15 billion cash stockpile, but even that was unlikely because Microsoft had the right to be paid back first in the event Facebook was acquired by someone else.

The extremely high valuation created a recruiting nightmare for Facebook. How were they going to attract new employees if their stock options weren’t worth anything until the company generated value in excess of $1.3 billion (the likely new appraised value of the Common Stock —1/3rd of $4 billion)?  Enter the RSU.

What are RSUs?

RSUs (or Restriced Stock Units) are shares of Common Stock subject to vesting and, often, other restrictions. In the case of Facebook RSUs, they were not actual Common shares, but a “phantom stock” that could be traded in for Common shares after the company went public or was acquired. Prior to Facebook, RSUs were almost exclusively used for public company employees. Private companies tended not to issue RSUs because the recipient receives value (the number of RSUs times the ultimate liquidation price/share) whether or not the value of the company appreciates. For this reason, many people, including myself, don’t think they are an appropriate incentive for a private company employee who should be focused on growing the value of her equity. That being said RSUs are an ideal solution for a company that needs to provide an equity incentive in an environment where the current company valuation is not likely to be achieved/justified for a few years. As a result they are very common among companies that have closed financings at valuations in excess of $1 billion (Examples include AirBnB, Dropbox, Square and Twitter), but are not often found at early stage companies.

Your mileage will vary

Employees should expect to receive fewer RSUs than stock options for the same job/company maturity because RSUs have value independent of how well the issuing company performs post grant. You need to discount the numbers found in our Startup Compensation Tool by approximately 10% to determine the appropriate number of RSUs for each private company job because our tool is based on private company stock option data.  By comparison you should expect to get about 1/3 as many RSUs as you would receive in options at a public company.

Let me provide a private company example to illustrate. Imagine a company with 10 million shares outstanding that just completed a financing at $100 per share, which translates to a $1-billion-dollar valuation.  If we knew with certainty that the company would ultimately be worth $300 per share then we would need to issue 11% fewer RSUs than stock options to deliver the same net value to the employee.

Here’s a simple chart to help you visualize the example.

Stock Option RSU
Company shares outstanding 10,000,000 10,000,000
Latest price/share paid by investors $100 $100
Company valuation $1,000,000,000 $1,000,000,000
Shares granted to employee 5,000 4,444
Shares as a % of shares outstanding 0.050% 0.044%
Exercise price $33.33 NA
Profit at $300/share $1,333,333 $1,333,333

 

We never know what the ultimate value of the company will be, but you should always expect to receive fewer RSUs for the same job to get the same expected value because RSUs don’t have an exercise price.

RSUs and stock options have very different tax treatment

The final major difference between RSUs and stock options is the way they are taxed.  We covered this subject in great detail in Manage Vested RSUs Like A Cash Bonus & Consider Selling. The bottom line is RSUs are taxed as soon as they become vested and liquid.  In most cases your employer will withhold some of your RSUs as payment for taxes owed at the time of vesting. In some cases you may be given the option to pay the taxes due with cash on hand so you retain all vested RSUs. In either case your RSUs are taxed at ordinary income rates, which can be as high as 48% (Federal + State) depending on the value of your RSUs and the state in which you live.  As we explained in the aforementioned blog post, holding on to your RSUs is equivalent to making the decision to buy more of your company stock at the current price.

In contrast, options are not taxed until they are exercised.  If you exercise your options before the value of the options has increased and file an 83(b) election (see Always File Your 83(b)) then you will not owe any taxes until they are sold. If you hold on to them, in this case for at least a year post exercise, then you will be taxed at capital gains rates, which are much lower than ordinary income rates (maximum of approximately 36% vs. 48%). If you exercise your options after they increase in value, but before you are liquid, then you are likely to owe an Alternative Minimum Tax. We highly recommend you consult with a tax advisor before making this decision. Please see 11 Questions to Ask When You Choose a Tax Accountant to learn how to select a Tax Advisor.

Most people do not exercise their options until their employer has gone public.  At that point it is possible to exercise and sell at least enough shares to cover the ordinary income tax owed on the appreciation of the options. The good news is, unlike RSUs, you can defer the exercise of your options to a point in time when your tax rate is relatively low. For example you might wait until you buy a house and are able to deduct most of your mortgage payment and real estate taxes. Or you might wait until you benefit from tax losses harvested by an investment management service like Wealthfront.

We are here to help

RSUs and stock options were designed for very different purposes. That’s why the tax treatment and amount you should expect to receive differ so much. We strongly believe that with a better understanding of how their use has evolved you will be able to make better decisions on what constitutes a fair offer and when to sell. We are also very aware of how complex and specific your own decision-making can be so please feel free to follow up with questions in our comment section —they are likely to prove helpful to others as well.


Disclosure

The information provided here is for educational purposes only and is not intended as tax advice. Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction.

 

Tags: ,

25 Responses to “How Do Stock Options and RSUs Differ?”

  1. Bruce Brumberg February 12, 2014 at 9:09 am #

    I write regularly on stock compensation topics for myStockOptions.com and wanted to tell you that I find your articles/blog insightful and have been referencing them to others. This is perceptive explanation of why RSUs became popular in private companies. You interestingly position this trend, which we have also seen in our site, as a response to large valuation that began with Facebook. Another explanation we have seen is that RSUs made it less likely the company would trigger the prior SEC rules for when companies had to make disclosures under the 1934 Act.

  2. MK May 7, 2014 at 1:34 pm #

    Hi,

    Thank you a lot for your very informative blog. Can you please explain what you mean with “If you exercise your options after they increase in value, but before you are liquid,”?
    Does exercising mean having the option to sell? I think I am lacking the exact meaning of “exercising” in this context? And what does “before you are liquid mean”?

    Thanks,
    Ghiath

    • Andy Rachleff May 8, 2014 at 10:17 am #

      A stock option is an instrument that enables you to purchase common stock at a fixed price (the exercise price) for an extended period of time. When you are issued your options upon taking your job, you receive an option agreement that states the number of options you receive, the exercise price and the vesting schedule. You may not sell the option. You must first exercise the option (ie pay for the stock) before you can sell and you can only sell exercised stock that has been vested).

      For example, lets say you were issued an option to purchase 4,800 shares at $3.00 per share vesting over 4 years. After two years you will have vested 2,400 shares. You could pay $7,200 to exercise those vested shares (2,400 x $3), but most people choose not to exercise until their company is publicly traded. Liquid in this case refers to ability to sell your stock which generally requires a public market (ie your company has had an IPO). If we further assume your company’s stock is publicly traded and the current price is $20 per share then you could sell those 2,400 shares for $48,000 and earn a $40,800 profit.

  3. Paul September 26, 2014 at 1:58 pm #

    Can you clarify for me the issue of making an 83(b) election with regard to private company stock options? I was told that I can’t make an 83(b) election with my private company options until after I exercise the option and acquire the (unvested) stock – then I can make my 83(b) election. Is that indeed the case? It’s confusing…

    • Andy Rachleff September 26, 2014 at 2:34 pm #

      You do not make an 83(b) election until you exercise your stock. You then have 30 days to do it.

  4. TKP October 12, 2014 at 9:25 pm #

    What are the implications of a company offering the same number of RSUs as stock options?

    • Andy Rachleff October 13, 2014 at 7:45 am #

      Offering the same number of RSUs as options is n incredible deal for the employee. It is usually only offered by a company that has very little confidence in its ability to grow the value of its stock.

  5. Andy Rachleff October 21, 2014 at 8:49 am #

    That sounds really strange. Why offer RSUs unless you don’t think the stock is likely to appreciate a lot?

  6. allison November 19, 2014 at 10:24 am #

    You say that “Employees should expect to receive fewer RSUs than stock options for the same job/company maturity because RSUs have value independent of how well the issuing company performs post grant.”
    How would an RSU have value if the company never has a liquidity event (or tanks)? It won’t, right?

  7. allison November 19, 2014 at 10:25 am #

    You say: “Employees should expect to receive fewer RSUs than stock options for the same job/company maturity because RSUs have value independent of how well the issuing company performs post grant.”

    How would an RSU have value if the company either never has a liquidity event or just goes under?

    • Andy Rachleff November 19, 2014 at 5:05 pm #

      Correct but I was addressing a different and more common scenario. RSUs are usually only granted in cases where a company is fairly successful. In the case of an acquisition, assuming it is sold for more than the total liquidation preference (which is almost always the case for companies that issue RSUs) or IPO then the RSUs are assured to have value whereas the options might not if the acquisition price or trading price of the stock is below the option price.

  8. alexis February 10, 2015 at 7:00 am #

    what is the benefit to the employer on whether they offer RSUs or options? my company used to offer options and at the last minute they changed it to RSUs (I was recently promoted and with my promotion as well as others, the offer changed).

    • Andy Rachleff February 10, 2015 at 2:24 pm #

      Employers usually only switch to RSUs when options are no longer an attractive incentive for new employees to join. Therefore the value to the company is the opportunity to attract more and better employees.

  9. mjr March 8, 2015 at 7:49 pm #

    In the example, the new investors enter at $100/ share yet the option exercise price at $33.33; is not the $100 the “fair value at date of grant”

    • Andy Rachleff March 8, 2015 at 9:22 pm #

      Venture capitalists buy convertible preferred stock which has certain attributes like preference and voting rights that cause it to have a much higher fair market value than common stock – thus the 3x difference in less mature private companies.

      Public companies typically only trade common stock so the exercise price is the closing price in the date on which is was granted.

  10. Mohit April 16, 2015 at 5:44 am #

    Hi Andy,

    I am a software professional, I am looking here for a suggestion, I got offer from a good growing company (rev > 1bn) and was offerd RSUs as part of the compensation. When I got offer this company was public but now that has been acquired and become private. So wanted to understand how this can impact my RSU benefits after going private form public.

    Appriciate your help.

    • Andy Rachleff April 16, 2015 at 2:55 pm #

      An RSU for a private company is no different than an RSU for a public company other than its immediate ability to be sold. It represents an ownership interest in your company that will have value once your company goes public again or is acquired.

      • Mohit April 16, 2015 at 11:58 pm #

        Thanks Andy, now furthur I would like to understand that what will happen when I will leave the company before it goes public or acquired? What will happen to the RSUs which has already vested for me ? Please let me understand all the possibilities, so that I can put right queries to my future company before I join them.

        Thanks again Andy, its realy very helpful :).

        • Andy Rachleff April 17, 2015 at 9:50 am #

          You get to keep the RSUs you vested. Once your company goes public or gets acquired your employer will issue you shares that take into account your taxes due. For example if your tax rate is 40% and you have vested 50,000 shares then they will distribute 30,000 shares to you after your stock becomes liquid.

  11. eef April 16, 2015 at 10:17 pm #

    Hi Andy,
    I have a silly question regarding RSUs. I recently joined a publically traded company that offered me 4K RSUs which are currently valued at $57 per share over a 4 year vesting period. As the stock fluctuates over time will that effect the value of my RSUs? Meaning is an RSU based on a strick price (at the point of agreement); or at the time of vesting, is it valued at the current stock price? Thanks so much!!

    • Andy Rachleff April 17, 2015 at 9:57 am #

      The value for tax purposes is the price at which your stock traded on the day you actually receive free to trade shares. There is no strike price for RSUs. Only stock options.

  12. Kumar April 27, 2015 at 11:58 am #

    Hi Andy,
    I have probably a basic question. I was issued some RSU(say 1000) couple of years back and the vesting is another year away. in the mean time, my company was acquired by another company. so in this case what is the Risk to my existing RSU’s given by my company before it was taken over. Is there a possibility of this(RSU) getting cancelled? Many Thanks in advance.

    –Kumar

    • Andy Rachleff April 27, 2015 at 1:28 pm #

      There’s no way they can be cancelled. However they may change your vesting schedule.

  13. Rayhan Qadri April 28, 2015 at 10:44 am #

    I have to decide in less then a week to either select RSU’s or options. You have explained in details both options. I very much appreciate that. MY RSU’s exactly as you mentioned are less compared to options. I am inclined to opt for RSU because of tremendous upside. Only question I have is that the only downside to RSU is capital gain tax the minute you are vested for any percentage of RSU grant.

    Are their any other up or downsides? I have opted for RSU at a previous employer and actually came out ahead of my friends who instead opted for options. This is second time around with RSU.

    • Andy Rachleff April 28, 2015 at 4:46 pm #

      Stock options have more upside than RSUs and better tax treatment. RSUs are taxed at ordinary income rates not capital gains rates when they vest.

      The fact that you came out better than your friends with RSUs in the past is irrelevant. The best choice depends on each particular situation

Have a Question?