Splitting The Cake – Options Or Restricted Stock Units (RSUs)?

For the longest time, the way to incentivize employees and sharing a piece of the action was exclusively through option grants rather than with restricted stick units (RSUs). Stock options offers a form of ownership to employees by giving them the right to purchase stocks in a company after certain conditions have been met (traditionally based on the time an employee has been actively working in the company or what is usually referred as the “vesting” period). These stock options have an price tag attached to them and the grantee has to pay an exercise price to buy the subjacent equity.

Stock Options

One of the issues with options is that if the current price of the stock is lower than the exercise price of the option, it doesn’t make sense for someone to exercise it (you would pay a certain amount to get stocks which are worth less than the price you paid for them). Depending on when these options were granted and the pre-defined exercise price, these options might be worthless. If this happens, employees can somehow lose their incentive to work long hours as their financial payout has been considerably reduced in the future.

Without entering in a too technical discussion, another consideration to take into account with options is their tax treatment. Because company usually grant options at an exercise price that is much lower than the current price of shares (usually compared to preferred shares), the exercise of these options could be taxed, diminishing their financial value to the holders. To avoid or reduce this tax component, companies usually need to get an external appraiser to justify the lower exercise price of the options (usually priced at 1/3 of the price of the stock paid by external investors) and go through several other paperwork requirements. If a company raises money at a very high valuation, the exercise price of the options will be high and the business will need to perform very well for employees to earn a difference at the time of exercise. This can be risky in a downturn environment for example.

Restricted Stock Units (RSUs).

A “new” way of incentivizing employees which is rapidly gaining traction within leading tech firms is the grant of RSUs. RSUs are usually shares of common stock which are also subject to vesting and other conditions. One restriction is for example to give the right to trade these RSUs for common stock only if there is a “liquidity” event (e.g. acquisition, IPO).

The important difference between RSUs and options is that RSUs have an intrinsic value whether the value of the company continues to increase or not. Contrary to options which might be worthless depending on the exercise price and stock price, RSUs are generally always worth something. This can have the negative effect of reducing the incentive for employees as they are “guaranteed” a certain value for their RSUs regardless of future valuations of the company. Obviously, their RSUs might be worth much more if the company continue its expansion but they don’t occur the same risk that with options. RSUs can provide a more security to employees.

When the value of a company is already very high, granting options might not be the best method as it could be hard for these options to really be worth something at the end of the day. RSUs solve this problem and this one of the reasons why large tech startups in the Silicon Valley such as Airbnb, Dropbox, Square, Uber) have been using  RSUs predominantly as they grew. RSUs can also help a founder keep a better control of its company by adding conditions and restrictions to them.

There is also a major difference in the tax treatment of RSUs compared to options. RSUs are taxed as soon as you have vested them and that they became liquid. From a tax point of view, they are considered as an ordinary income. On the other hand, employees get taxed on options only when those are exercised. Gains on options are considered a capital gain (which has a lower tax rate) rather than an income.

At the end, the choice between granting options and RSUs will depend on the stage of the company, its legal and financial structure and how each plan might be the best at incentivizing employees. What matters it to gather as much information as possible with a legal counsel before taking a decision which will have have long-term repercussions.