Stock Options Vs Restricted Stock Units (RSUs)
In addition to free fruit and ping pong tables, one of the key incentives that technology companies offer prospective staff is stock. Depending on the evolution of the company these typically come in the form of stock options or RSUs (Restricted Stock Units). Trying to understand the differences and perceived value can be daunting at first.
What is a stock option:
Stock options tend to be a good choice for early-stage, high-growth start-ups where values are likely to significantly increase in value, particularly as the company scales and secures future funding rounds. These companies typically do not have revenue, they may not even have a product. The risks are greater- they may never become profitable but in return, if they are successful then the rewards can be much higher.
With stock options, employees are given the right to purchase the stock at a finite time for a predetermined price, like a call option. They will be subject to Capital Gains Tax on disposal but if the option scheme is set up efficiently there is no tax to pay until disposal.
If you are being offered stock options, in your offer letter, there will typically be a reference to a stock option agreement which will detail the type of stock options you get, how many shares you get, your strike price, and your vesting schedule.
Your stock option agreement should also specify its expiration date. Vesting means you must earn your employee stock options over time. Companies do this to encourage you to stay with them and contribute to their success. A traditional vesting schedule usually includes a “cliff.” A cliff is the first chunk of shares that vest. For example, if you have a one-year cliff, which is relatively standard, this means after one year you can buy a % of your options.
Without the cliff, you could accept the offer, work for a few months, buy a bunch of the company’s stock, and then quit. If your option grant includes a cliff, it prevents that.
The other aspect to consider is the vesting period – typically this is 3 or 4 years but can be longer or shorter. For example, if you have a 4-year vesting period you will normally receive 25% each year, hence completing the full grant over 4 years.
Typically, if you leave the company, your shares will stop vesting immediately and you can only buy shares that have vested as of that date.
Example of stock option calculations (note this are approx. figures and should only be used as a guide):
100,000 options may sound a lot, but 10,000 options with another company could be worth more - it depends on the total shares outstanding.
So, in this example if we assume there are 1,000,000 shares outstanding:
- Current value of company is 10,000,000 GBP
- You are offered 1000 shares, therefore 0.001% equity, current value -10,000GBP
- The share vest 25% each year with no cliff, so at the end of year 1 you would have 250 shares
- If we assume the company successfully exited 5 years after you joined at a 10x multiplier, then the value of your shares at exit will be 100,000GBP minus the cost to exit (strike price, taxes etc)
What is an RSU:
It’s less common for start-ups to grant RSUs. If they choose this route, they will have to have sufficient cash reserves to fund the taxes. For companies with reliable income streams, RSUs make more sense. Also, when the market value of the common stock is too high to motivate employees to buy stock options, RSUs also make more sense.
An RSU is a promise from the employer to provide you with the company’s shares in the future on a certain date. For RSUs you do not have to pay anything, unlike stock options. With RSUs, there is no tax when they are granted, but when they vest you are subject to both income tax and NIC (National Insurance Contributions). The amount to be taxed is dependent on the market value of the shares at the time at which you are awarded. Furthermore, if you decide to sell the shares and make a gain, it would be taxed at the applicable capital gains rate.
However, in contrast to stock options, RSUs will typically have some intrinsic value and you will effectively always be “in the money”.
Example of RSU calculations (note these are approx. figures and should only be used as a guide):
As an example, suppose Lily receives a job offer and they offer her 1,000 RSUs in addition to a salary and other benefits, vesting over 5 years.
The company's stock is worth £30 per share, making the RSUs potentially worth an additional £30,000.
Lily receives 200 shares each year until she acquires all 1,000 shares at the end of the vesting period. Lily will be free to sell the shares once vested, and typically if she left within the 5 years she would lose the unvested shares.
Even if the share price falls to £20 she will still be ‘in the money’ and her shares after 5 years would be worth £20,000. If the share price increases by 50%, then her shares will be worth £45,000.
From the two examples, you can see the difference in the potential upside between stock options and RSUs- greater risk, greater reward.
Stock options and RSUs are both popular forms of equity compensation and a key driver in the attraction and retention of employees.
Evaluation of stock options is more complicated than RSUs, there are lot more factors to consider such as class of stock, potential dilution, good leaver provisions etc and one can write a whole book on the nuances.
But what we have seen over the last few years is an expectation from candidates to be offered stock options or RSUs and this can be a key factor in whom they chose as a future employer.