Restricted Stock Units vs Incentive Stock Options

repvue
repvueFeb 15, 2021
Hopefully the chart looks like this…

A few weeks ago we wrote about how you should value the equity you’ve been awarded in your sales job offer, and we’re thankful for all the positive feedback we’ve received about this post and how it’s directly helped some of our users.

A few of our users wrote us back and asked us about various types of equity and understanding the differences between them, so as a follow on to our “Valuing Your Equity” post, we’re adding a short summary of two of the most common types of equity that you might see in your career.

Incentive Stock Options

Work at a venture backed software company?  A common form of equity in early stage or VC backed companies are incentive stock options (ISOs). The term ‘option’ is important here because you (the employee) are being offered the option to purchase stock in the company at a specified price.  There are a few considerations that are most important when evaluating an ISO award.

First, the price (aka strike price).  This is the price at which you, the employee, will have to pay to purchase each stock option.  So for example if the strike price is $0.25 (25 cents) when you exercise, say, 2,000 options, you’ll have to cut a check to the company for $500 ($2,000 times $0.25).  Now ideally as time goes by the value of the company, and thus the value of each share, goes up while the cost to you remains set at $0.25, but that isn’t guaranteed.

To clarify, when we reference ‘exercise’ your stock options, that means you are exercising your option to purchase those shares.

Second, the vesting schedule.  You’ll have a vesting schedule for your options, most common is four years, and your ISO award will typically vest on a schedule over that time period.  A typically vesting schedule might be quarterly over 4 years, so for example if you’re offered 4,000 options in an award with a quarterly vesting of 4 years, you’ll vest 250 options starting three months after the award and another 250 options will vest after each additional 3 months, until your vesting is complete.

Vesting some of the options simply means that you are eligible to purchase those options.  Employers don’t want to just offer you the 4,000 options up front that you can exercise and then bolt.  

Since this may still be a privately held company, it’s not a certainty that the options that you exercise (i.e. pay for) will be worth any money at all, so take care to evaluate the company and its prospects for long term success.  It’s also important to seek tax advice from a qualified professional on the tax implications of exercising your options, although generally the tax treatment of ISOs is that they are not taxed until they are sold.  Also note you must have held them 2 years from grant date AND 1 year from exercise date to qualify for capital gains treatment.

If you hold ISOs and the shares are now able to be liquidated (maybe the company went public or was acquired by a public company), employees would be able to use a ‘cashless exercise’ whereby the employee would not have to pay out of pocket to exercise the shares, instead the company would sell just enough of the shares to cover your exercise cost.

Restricted Stock Units

With the background of the ISOs, we can pivot to RSUs, or restricted stock units.  Restricted stock units (or sometimes called restricted stock awards or RSAs) have a number of similarities to ISOs with a couple key differences

First, RSUs don’t have a strike price.  So you’re offered equity and when the units are eligible to be exercised, there isn’t a strike price.  So in that light, they may be viewed as favorable to ISOs.  This is extremely advantageous because with a $0 strike price, the RSU should always be worth something, even if it’s a small amount.  With ISOs, it’s certainly possible to have a strike price that’s higher than the actual value of the share (hence the term my equity is under water).

Second, while RSUs are also subject to a vesting schedule, the RSU vesting schedule is typically an annual vesting schedule, vs. a quarterly vesting schedule.  In other words you may still have a four year vesting period, but a chunk of the award would be exercisable after 1 year, another after year 2, and so on – again typically a four year period is normal.

Third, carefully look at the treatment of the award if / when you leave the company.  Both ISOs and RSUs will expire when you leave the company, but typically there is a grace period of time to exercise the ISOs after you leave (generally between 30 and 120 days).  Many times the RSUs will expire if you are no longer employed.

Lastly, with RSUs, when they vest, they are typically taxed as ordinary income, although many companies will automatically sell enough of them to cover that tax amount that you owe.  Then if you hold those RSUs for a period of time without selling, you may be subject to taxes on the increased value of the units/shares.

Ping us back and let us know if you have any more detailed questions on this, and we’ll probably share the Q/A on LinkedIn when we share this article there.

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