Thinking of a way to incentivize your employees? Thinking outside the box to motivate your staff to work harder for the company can be difficult. Along with the standard salary, you can try offering your employees with some additional compensation in the form of equity. However unless you’ve taken a crash course in options 101, you might not know all the incentives you can offer your employee.
Let us begin with understanding both the types in detail.
Stock options are perks that many companies offer their investors, consultants, contractors, and employees. A company grants stock options through a contract that offers employees the right to purchase a fixed amount of shares of the company stock at a predefined rate. The offer only lasts for a specific amount of time to exercise the options before they expire.
There are two kinds of employee stock options including non-qualified stock options (NSOs) and incentive stock options (ISOs). The main difference between them is when and how they are taxed. To give you an idea, ISOs enjoy a special tax treatment. The number of options offered depends on the company’s plan and position of the employee. Also, before an employee can get the stock options, the investors and stakeholders would have to sign for its approval.
Stock option agreement
If you are about to offer stock options to your employees, there has to be a stock option agreement for it. This agreement is also referred to as option grants, and it is the document that allows employees to exercise the options later on. This document would include the details such as the type of stock options offered, the number of shares offered, the strike price, and the vesting schedule.
The agreement should also have an expiration date of the shares. Normally, ISOs take 10 years to expire from the grant date. It is important for the company to mention the expiration date on the option grants so that the employee can exercise them before they expire.
Example: How do Stock Options Work for Granting and Vesting?
For you to understand how stock options work, let us take a simple example. Let’s assume that Kevin gets a job in a new company and gets 20,000 shares of the company stock. Kevin and the company would first have to sign a contract that outlines the terms of the stock options, which might be included in the employment contract.
The contract will specify the grant date, which is the day the options begin to vest for Kevin. When a stock option vests, it means that it is actually available for the person to exercise, that is to buy. Unfortunately, Kevin will not get all the options as soon as he joins the company. Instead, he will get them gradually over a period of time which is deemed the vesting period.
Let’s say that the options have a 4-year vesting period and a 1-year cliff. This means that it would take about four years before all the shares are vested. And once this period ends, Kevin will be able to exercise all 20,000 share options. The good news in this is that even though the options vest over a long period, Kevin will be able to access a part of the stock before the four years are completed.
Kevin will have 5,000 shares vested after the first year ends and 10,000 after the second year. The bad news here is that there is a waiting period before any of the options vest. Kevin will have to stay with the company for at least a year before he can get any of the options. And if he leaves the company before the one year, he will not get anything. This is the purpose of the 1-year cliff.
Once the one year passes by, Kevin will get his first 5,000 shares and the remaining will vest equally every month for the next three years. Kevin will get 1/36 of 15,000 shares remaining for the next 36 months, which is 416 options per month. And if he leaves in between, he will only get the vested options and would have a very small window of time to exercise them.
RSU or Restricted Stock Units
Restricted stock units, or RSUs for short, are a form of compensation issued to the employee in the form of company stock. Restricted stock units are issued to an employee through a vesting plan and distribution schedule after achieving the required performance milestones or upon remaining with their employer for a particular length of time.
Restricted stock is a form of executive compensation that has become much more popular after the accounting scandals that happened in the mid-2000s involving companies like WorldCom and Enron. It was created as a much better alternative to stock options. At the end of 2004, the Financial Accounting Standards Board (FASB) issued a statement requiring companies to book an accounting expense for stock options issued. This action leveled the playing field among equity types.
Before the 2000s, stock options were the choice of equity compensation. But due to the issues with tax-evasion, malpractice, and sandals, a lot of companies now can easily use other kinds of alternative including RSUs, which is much more effective.
How is RSU stock restricted?
For an employee to get RSUs from the company as compensation, certain restrictions must be met. These restrictions are usually:
- Milestone-based (e.g. your company undergoes an IPO or is acquired)
- Time-based (e.g. you stay at the company for a certain amount of time)
- A combination of the two (most RSUs issued at privately held companies have both a time-based and liquidation condition)
The moment the employee meets the specified restrictions outlined in the RSU grant, they will have their RSUs vested and can then get their shares. Once the employee gets the RSUs and if the company is publicly traded, they can sell their shares instantly on the market. On the other hand, in the case of a private company, the employee will have to wait for a liquidity event (like an acquisition or IPO) or, if the company approves, find a willing buyer.
Here are some things that the employees should consider when thinking about selling their RSUs:
- What is your company’s trading policy
- How much will you be taxed?
- What are your cash-flow needs
- How do you think the stock will perform in the future?
- How diverse do you want your portfolio to be?
Differences between RSU’s and Stock Options
Restricted stock units and options are like apples and oranges. Obviously, both offer the employees stock in the company. But from the amount of taxes to be paid, when to pay them, and the choices the employee needs to make, they behave very differently.
Let us talk about the differences between each based on various aspects as below:
The very first difference between RSUs and the options are the rights given to the shareholders. For stock options, the employee receives the full rights of the shareholders. This includes both the dividend and voting rights. On the other hand, RSUs holders don’t receive full rights. Basically, voting rights are not given and the dividends are also not paid.
As mentioned above, stock options have dividend rights but they rarely carry the dividend equivalent rights. And restricted stock entitles you to get dividends only when they are paid to shareholders.
Another huge difference between stock options and RSUs is what happens when the vesting period is over. With stock options, once that period ends, those options become common stock. In such a case, the employee has the choice to either buy or sell that stock.
On the other hand, an RSU is settled as outlined in the terms. The employee can ask that an employer defer settling the option for a short time frame after vesting, thus putting off paying income tax on it a little longer. However, in doing so, the employer has to make sure all tax laws are carefully followed.
4. Tax Treatment
During tax time, there will be a lot of differences between how you deal with stock options and RSUs. With stock options, as soon as the shares are sold, the capital gains tax would have to be paid on the amount earned as profit. Additionally, if the stock options are non-qualified, the income tax would also have to be paid for the amount gained along with the capital gains tax.
However, for RSUs, the shares are taxed at the FMV at the time when the shares vest. Income tax is paid on the FMV of the RSUs and tax is withheld from the employee’s paycheck by the company, which is given to the government. But if the company offers the shares to the employee instead of settling, and the employee holds the shares for more than a year, they would have to pay capital gains tax on it as well.
Non-Qualified vs ISO (Incentive Stock Options)
As shared above, there are two kinds of stock options, namely incentive stock options and non-qualified stock options. Here are the main differences between them:
- Non-qualified stock options can extend to numerous people that support an organization, including consultants and outside directors. NSOs are more of a perk offered to all employees as part of the recruiting process and receive no special tax treatment.
- Incentive stock options on the other hand, generally stay within the immediate staff, serving as an “incentive” for team members to boost performance. These are most often seen with CEOs, CFOs and other team leaders who are considered part of the executive team. Unlike NSOs, ISOs tend to receive preferential tax treatment since lawmakers tend to think these types of high-level incentives strengthen the overall economy.
Comparing the benefits of RSU and Stock Options
Finally, stock options are considered as a great choice when used as an employee benefit. The reason is simple; small companies have always struggled to get the best talents in their company and compete with large corporations. But by offering the employees with options, it has become easier to attract good talent to a small company. Many find that stock options work as a great incentive to work hard and grow the company for the executive level.
Selecting the right kind of options to offer your employees depends entirely on how you want them to benefit from it. To recap, stock options are when a company gives an employee the ability to purchase stock at a predetermined price at a given time. This may occur on a vesting schedule, where a number of shares become available each year over a series of years.
On the other hand, restricted stock units are grants of a stock that a company gives to an employee without any purchase. Employees get these either as shares or a cash equivalent. With the difference between them clear now, you can make the right choice. And while you plan to give out shares to your employees, remember that you need to keep track of them in the company. For this, Eqvista is a great application that can help you.