Employee stock options (ESOs) and restricted stock units (RSUs) are two different types of equity compensation. An employee stock option gives an employee the option to buy company stock at a certain price, by a certain date. By contrast, an RSU is the promise that on a future date the employee will receive actual company stock.
Sometimes, employees get a choice between ESOs and RSUs. Understanding how each stock plan works, how they differ — particularly when it comes to vesting schedules and taxes — can help you make a decision that best aligns with your financial goals.
What Are Employee Stock Options (ESOs)?
Employee stock options (ESOs) give an employee the right to purchase their company’s stock at a set price — called the exercise, grant, or strike price — by a certain date, assuming certain terms are met, usually according to a vesting schedule.
If the employee doesn’t exercise their options within that period, they expire.
Companies may offer stock options to employees as part of a compensation plan, in addition to salary, 401(k) matching funds, and other benefits. ESOs are considered an incentive to help the company succeed, so that (ideally) the stock options are worth more when the employee chooses to exercise them.
In an ideal scenario, exercising stock options allows an employee to purchase shares of their company’s stock at an exercise price lower than the current market price — and realize a profit.
Note that while some of the terminology used with regard to employee stock options may sound similar to standard stock options, don’t get the two confused. Options are derivatives traded based on the value of underlying securities, e.g. stocks, bonds, ETFs.
How do ESOs Work?
Generally, ESOs operate in four stages — starting with the grant date and ending with the exercise date, i.e. actually buying the stock.
1. The grant date
This is the official start date of an ESO contract. You receive information about how many shares you’ll be issued, the strike price (or exercise price) for those shares, the vesting schedule, and any requirements that must be met along the way.
2. The cliff
If a compensation package includes ESOs, they’re generally not available on day one. Contracts often include requirements that must be met first, such as working full time for at least a year.
Those 12 months when you are not yet eligible to exercise your employee stock options is called the cliff. If you remain an employee past the cliff date, you get to level up to the vesting period.
Some companies include a 12-month cliff to incentivize employees to stay at least a year. Other companies may have a vesting schedule.
3. The vest
The vesting period is when you start to take ownership of your options and the right to exercise them. Vesting can either happen all at once or take place after a cliff (as noted above), or gradually over several years, depending on your company’s plan.
One common vesting schedule is a one-year cliff followed by a four-year vest. On this timeline, you’re 0% vested the first year (meaning you aren’t eligible for any options), 25% vested at the two-year mark (you can exercise up to 25% of the total options granted), and so on until you own 100% of your options. At that point, you’re considered fully vested.
4. The exercise
This is when you pull the financial trigger and actually purchase some or all of your vested shares.
ESO’s Expiration Date
While the expiration date of stock options isn’t always front and center, it’s important to bear in mind. The strike price you’re given as part of your options package expires on a certain date if you don’t exercise your shares.
One common timeline is 10 years from grant date to expiration date, but specific terms will be in the contract, and it’s important to vet the timing of your ESOs — as part of your career as well as your tax and your long-term financial plan. Again, if you let your stock options expire, you lose the right to buy shares at that price.
Pros and Cons of Employee Stock Options (ESOs)
If you land a job with the right company and stay until you’re fully vested, exercising your employee stock options could potentially lead to gains.
For example, if your strike price is $30 per share, and at the time of vesting the stock is trading at $100 or more per share, you’re getting a great deal on shares.
On the other hand, if your strike price is $30 per share and the company is trading at $10 per share, you might be better off not exercising your employee stock options until the price goes up (when and if it does; there are no guarantees).
That’s why ESOs are considered a form of employee incentive: You may work harder to help the company grow, if you know your efforts could translate to a bigger stock price.
Tax Implications of Employee Stock Options
Given that stock options can generate gains, it’s important to know how they are taxed so you can plan accordingly.
Generally speaking, employers offer two types of stock options: nonqualified stock options (NSOs or NQSOs) and incentive stock options (ISOs).
Nonqualified Stock Options
NSOs are the most common and often the type offered to the general workforce. NSOs have a less favorable tax treatment, because they’re subject to ordinary income tax on the difference between the exercise price and the market price at the time you exercise your options and purchase the stock.
NSOs are then taxed again at the capital gains rate when you sell the shares.
Your individual circumstances, tax filing status, and the terms of your stock options may also play into how you’re taxed, so you may want to consult a professional.
Incentive Stock Options
ISOs are “qualified,” meaning you don’t pay any taxes when you exercise the options — unless you’re subject to the alternative minimum tax (AMT).
You will owe taxes, however, if you sell them at a profit later on. (If you don’t sell, and if the stocks gain or lose value, those are considered unrealized gains and losses.) Any money you make when you sell your shares later would be subject to capital gains tax. If you hold your shares less than a year, the short-term capital gains tax rate equals your ordinary income tax rate, which could be up to 37% for the highest tax bracket.
For assets held longer than a year, the long-term rate is lower: 0%, 15%, or 20%, depending on your taxable income and filing status.
What Are Restricted Stock Units (RSUs)?
Restricted stock units, or RSUs, simply grant employees a certain number of shares stock by a certain date. When employees are granted RSUs, the company holds onto the shares until they’re fully vested.
The company determines the vesting criteria — it can be a time period of several years, a key revenue milestone, and/or personal performance goals. Like ESOs, RSUs can vest gradually or all at once. When the employee gets their shares, they own them outright; employees don’t have to buy RSUs.
How Do Restricted Stock Units (RSUs) Work?
RSUs are priced based on the fair market value of the stock on the day they vest, or the settlement date. The company stocks you receive from your company will be worth just as much as they would be if you purchased them on your own that same day.
If the stock is worth $40 per share, and you have 100 shares, you would get $4,000 worth of shares (assuming you’re fully vested and have met other terms).
Again, the main difference between stock options and restricted stock units is that you don’t have to purchase RSUs.
As long as the company’s common stock holds value, so do your RSUs. Upon vesting, you can either keep your RSUs in the form of actual shares, or sell them immediately to take the cash equivalent. Either way, the RSUs you receive will be taxed as income.
And, of course, if you later sell your shares you may realize a gain or a loss and there will be tax implications accordingly.
Pros and Cons of Restricted Stock Units (RSUs)
One good thing about RSUs, similar to ESOs, is the incentive to stay with the company for a longer period of time. If your company grows during your vesting period, you could see a substantial windfall when your settlement date rolls around.
But even if the stock falls to a penny per share, the shares still awarded to you on your settlement date. Since you don’t have to pay for them, it’s still money in your pocket.
In fact, you may only lose out on money with RSUs if you leave the company and have to forfeit any units that aren’t already vested, or if the company goes out of business.
Tax Implications of RSUs
When your RSU shares or cash equivalent are automatically delivered to you on your settlement date(s), they’re considered ordinary income and are taxed accordingly. In fact, your RSU distributions are actually added to your W-2.
For some people, the additional RSU income may bump them up a tax bracket (or two). In those cases, if you’ve been withholding at a lower tax bracket before your vesting period, you could owe the IRS more money.
As with ESOs, if you sell your shares at a later date and make a profit, you’ll be subject to capital gains taxes.
| ESOs | RSUs | |
|---|---|---|
| Definition | An employee can buy company stock at a set price at a certain date in the future. | An employee receives stock at a date in the future (does not have to purchase them). |
| Pricing | The strike price is set when ESOs are offered to an employee, and they pay that price when they exercise their shares. | The share price is based on the fair market value of the stock on the day the shares vest, and employees get the full-value shares. |
| Tax implications | The difference between the strike price and the stock’s value on exercise is considered earned income and added to your W-2, where it’s taxed as income. If you sell your shares later at a profit, you may also be subject to capital gains tax. | RSU shares (or cash equivalent) are considered ordinary income as soon as they are vested, and are taxed accordingly. If you sell the shares later, capital gains tax rules would apply. |
The Takeaway
Employee stock options (ESOs) and restricted stock units (RSUs) are two different types of equity or share-based compensation, and they each have their pros and cons.
An employee stock option gives an employee the option to buy company stock at a certain price, by a certain date. An RSU is the promise that on a future date the employee will receive actual company stock (without having to purchase the shares).
Because these types of compensation are often considered incentives, they’re designed to encourage employees to stay with the company for a certain amount of time. As such, employees often don’t get their options (in the case of ESOs) or the actual shares (in the case of RSUs) until certain terms are met. There may be a vesting schedule or company benchmarks or other terms.
Having the option to own stock in your employer company has the potential to provide attractive financial benefits, especially if you believe in the company and its future. This belief in a company’s growth potential is what may drive investors to buy a company’s stock, even if they don’t work there.
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